The Quantitative Analysis of Investor Behavior Report by Dalbar Inc. presented a rather discouraging fact in April: While the S&P 500 returned an average of 11.11% annually over the last 30 years, individual investors only averaged 3.69%.
Michael Mauboussin, one of the nation's leading authors on the subject of behavioral finance, says, “Most of us think of ourselves as different, and better, than those around us, especially in our supposed areas of expertise. Moreover, we are prone to see our situation as unique and special. But in almost all cases, it isn't.”
In fact, there's no evidence that professionals make better investment decisions than individual investors. When investment professionals say they are 80% certain that their stock will go up, they are only right about 40% of the time. Sadly, their performance is even worse than chance. While many investment professionals think they are special, they are overconfident in their abilities to forecast the direction of stocks.
Human beings simply aren't geared right to make good investments decisions. Due to a number of inherent biases, we tend to be impulsive, impractical and unrealistic about the future. This large collection of behavioral biases is constantly conspiring to limit our abilities from making good financial decisions.
What we lack in our ability to make investment decisions we make up for in other areas. We are good in areas that don't involve thinking about the future, such as adapting to our physical and social environments. This gap in our ability when it comes to investment decision-making, holds equally true for both individuals and “experts.”
According to Bob Seawright, in an article he wrote this month for Research Magazine, “Evidence 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.” In fact, one study suggests that smarter people are more vulnerable to thinking errors. Moreover, those who are aware of our own biases are no better at overcoming them.
DATA-DRIVEN INVESTMENT DECISIONS
For these reasons, we believe, that your investment process should be data-driven. Equally important, is the discipline to monitor, evaluate and adjust the investment process to assure it is performing appropriately as markets change. You should avoid all gut-level investment decisions. For many investors, this is the equivalent of learning a new language. And guess what: your natural inclination is to say “Forget it. I don't want to learn a new language.” If you keep making gut-level investment decisions, your results will likely suffer.
Investment professionals also resist the idea of removing subjectivity. They are under the false impression that they are “different and better” than the rest of us. They too end up making “educated guesses” about the future.
CXO Advisory has been tracking investment gurus since 1998 and their research shows that the likes of Jim Cramer, Marc Faber, Robert Prechter and a long list of others are able to make correct forecasts 46.9% of the time.
THE BEST MONEY MANAGERS
In my more than 35 years in the investment industry, I have found it comes down to this: the best money managers are teams of people who create data-driven statistical models with formal investment rules that can adapt to changing markets.
Of course, investment models work — until they don't. Eventually even the best models stop working or at best need some minor adjustments. That's right, no investment process is so reliable that it can go unattended. We need look no further than the implosion of Long Term Capital Management in the '90s to know that even the most sophisticated investment process can fail.
Given the critical importance of developing a non-biased, objective, model-based investment process, it is still important to use good judgment in the implementation of the process. That judgment is not to over-rule the data-driven decisions, rather it's to continually evaluate the process and make necessary adjustments.
Here are five steps to making better investment decisions:
• Choose a purely data-driven investment process. No gurus!
• Establish procedures to systematically review and improve your process.
• Focus on the process, not the results. If the process is good, good results will follow.
• Focus on what could go wrong. A strong defense is the key to winning.
• Eat your own cooking. This one is really for investment managers. If your process isn't good enough for you, it's not good enough for your clients.