After compiling 30 years of data and after issuing 20 reports finding that individual investors underperform by virtually any measure, this year’s Quantitative Analysis of Investor Behavior (QAIB) report from Dalbar, issued in April, offered a new and daunting conclusion.
“Attempts to correct irrational investor behavior through education have proved to be futile. The belief that investors will make prudent decisions after education and disclosure has been totally discredited. Instead of teaching, financial professionals should look to implement practices that influence the investor’s focus and expectations in ways that lead to [more] prudent investment decisions.”
For the 30 years ending Dec. 31, 2013, this year’s QAIB disclosed that equity fund investors earned an average annual return of 3.69% compared with the S&P 500′s 11.11%. “After enormous efforts by thousands of industry experts to educate millions of investors” that the report concludes were “ineffective,” Dalbar recommends four best practices for financial professionals: set expectations below market indexes, control exposure to risk, monitor risk tolerance and present forecasts in terms of probabilities.
That’s good advice for advisors, of course, but it doesn’t offer suggestions for how those advisors can make better decisions themselves. That’s a crucial point because there is little reason to expect them to be significantly better decision-makers than consumers. For example, professional investors are seriously overconfident and trade too often. They exhibit “herding” behavior. Moreover, when professional analysts are 80% certain that a stock is going to go up, they are right about 40% of the time—which is worse than pure chance.
A variety of behavioral and cognitive biases constantly conspire to limit the abilities of laypeople and professionals alike to make good investment decisions. Accordingly, we’re right to be skeptical about our decision-making abilities in general because our beliefs, judgments and choices are so frequently wrong.
Recent evidence even suggests that being smarter, more aware or more educated doesn’t seem to help us deal with these cognitive difficulties more effectively. Indeed, they may actually make things worse. For example, one study suggests that, in many instances, smarter people are more vulnerable to thinking errors, even basic ones. Moreover, “people who were aware of their own biases were not better able to overcome them.”
Because our intuition isn’t trustworthy, we need to be sure that our investment process is data-driven at every point (a point I have made before in these pages). We need to be able to check our work regularly. Generally speaking, the key is to use a carefully developed, consistent process to limit the number of decisions to be made and to avoid making “gut-level” decisions not based upon good evidence; but also to be flexible enough to adjust when and as necessary.
The very best performers are great teams of people who create careful, data-driven statistical models based upon excellent analysis of the best evidence available in order to establish a rules-driven investment process. Yet, even at this point, the models are not of the be-all/end-all variety. Judgment still matters because all models are approximations at best. These models only work until they (inevitably) don’t anymore—consider the implosion of Long-Term Capital Management in the late 1990s, for example.