This post is the last in a series in which I share some insights from my recent interview with Meir Statman, one of the world’s leading scholars of behavioural finance. At the end of the post, I’ll tell you how you can win a copy of Prof. Statmans’s fascinating new book, What Investors Really Want.
It’s natural for human beings to be overly confident in our own abilities. You’ve probably heard about the famous famous study in which about four out of five people rated their own driving skill as above average.
This tendency to overrate our own skill is sometimes called the Lake Wobegon Effect, after radio personality Garrison Keillor’s fictional town where “all the women are strong, all the men are good-looking and all the children are above average.”
You can imagine that 100% of active fund managers are convinced that they can outperform the market. But this is impossible, since every invested dollar that beats the market must be balanced by another dollar that lags by an equal amount.
The idiot on the other side of the trade
Prof. Statman uses a fresh analogy to explain our overconfidence as investors. He compares active investors to tennis players who think they are hitting the ball against a practice wall, when in fact they are playing against another player who may be more skilled. He goes on to say that entrepreneurs do not make this same mistake. I asked him to elaborate:
“Investors generally don’t think about this simple question: ‘If I am buying a stock because I think it is going to go up, who is the idiot who is selling it to me?’ They don’t think about investing like playing tennis against a possibly more skilled opponent. They ignore the likelihood that the person on the other side has some inside information, or a computer program that enables them to take advantage of an opportunity. They don’t realize that they might in fact be that opportunity, and that someone else’s gain may come at their expense.
“There is another analogy that I make, which is that if I go to the supermarket and tuna is on sale for $1 and it usually costs $2, I’m going to stock up. If the store runs out of tuna, I can always get a rain check that guarantees me that lower price. That’s a real sale. What investors don’t get is that when the guy on television says this stock is a bargain, other people hear that, too. And by the time you get to the market, it might not be a bargain anymore, even if the person on TV was right at the time.
“Entrepreneurs are different, because they are keenly aware that they are in competition against players on the other side of the net. If they are not aware of their competition they’re going to be in trouble very quickly. So they constantly ask themselves, ‘Is somebody selling the same product at a lower price?’ or ‘Is somebody selling a better product at the same price?’ or ‘Is somebody introducing a new product that is going to kill mine?’ In this sense, they know they are playing tennis against a real opponent.”
I would argue that Couch Potatoes, unlike active investors, are closer to the tennis player who is hitting the ball against the practice wall. Unless they are actively trying to time the market, investors who buy broad-based index funds aren’t doing so because they think they’re outsmarting an idiot on the other side of the trade. They’re simply making the decision to accept market risk with the expectation that they will be rewarded over the long-term.
Win a copy of What Investors Really Want
Now it’s time to give away a couple of copies of Prof. Statman’s book, What Investors Really Want. I’ll draw two names at random from all of the entries I receive before Friday, January 14, at 11:59 pm EST. There are two ways to enter:
- Tweet this post to your followers. Be sure to include @CdnCouchPotato in the tweet so I can track it.
- Post a comment below and share what you think is the biggest behavioural bias you face in your own investing.
Good luck to all entrants. Winners will be announced on Monday, January 17.
Being newer to investing I still get swayed by the ups and downs, specifically when a stock reduces it’s dividend. That makes me upset and I react. Need to work on this.
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The most difficult thing about passive investing is to remain passive. The DIY investor of any flavour tends to take a somewhat active approach if not by excessive trading or market timing, but by reading variuos blogs and posts. This in and of itself causes us to second guess some of our decisions and wonder if perhaps there is some better approach to investing than what we currently employ. This to me is one of the hardest things, to stick with what seemed like the best decision not so long ago….
Since I began investing, Canadian equities have been doing well and the temptation to be a home country investor exclusively has tugged at me, however, I decided to allocate globally using unhedged instruments and plan on staying that way for the long haul.
The biggest issue I have with passive investing is staying patient! The glamor and sex appeal of short selling, stocks investing etc… seems like a quick and easy fix for fast cash! So remembering the turtle winning the race and not the rabbit is always a hard lesson to remember.
Right now I have 50% active and 50% passive (counting cash).
As each individaul stock or bond reaches a sell signal, I’m replacing it with an Index ETF or Cash waiting for an entry point.
I’m hoping to end up mix of 20% active and 80% passive.
The 20% active I hope to use Sector ETFs and the 80% passive in Index ETFs.
There’s still the Greed in me to beat the Benchmark.
I wholeheartedly agree with Tom about the difficulty of staying the passive course… I think this may have something to do with the fact that active traders feel they are more in control of their investments—even if it’s really the market calling the shots. Like him, I also tend to overload on information to compensate for my passive approach. The silver lining? I now know a great deal more about investing and I’m invested in a long-term strategy that I actually understand. That’s more than the average day-trader can claim!
My biggest problem, is not to take profits from time to time, thinking that the stock can do even better. Especially with cyclical stocks, one needs to take profits when the stock has reached a reasonable target. I’m keping my large cap dividend stocks forever unless fundamentals change significantly.
Definitely the number one bias in my investment approach is that I’m only invested in Canadian equities. Since I plan to live and retire in Canada, I don’t see the point in foreign diversification. The last economic crisis affected the entire globe, not just specific countries. I know Cdn. equities have been on a great ride for the past decade, but it’s a ride I’m planning on enjoying in retirement.
I am very new to investing so i hope I can stick with the passive approach and not get lured into something else.
The biggest behavioral bias for me is impatience. I feel like my generation has gotten accustomed to getting what we want, when we want it; so starting a portfolio from square one seems to take an eternity. It’s hard to build a respectable portfolio at my age (26) while getting my first mortgage, paying for bills and courses to complete my professional designation. It’s discouraging because I love to read about investment strategies but am not yet in a position to necessarily follow them fully.
Thanks Dan for the great site – I will continue reading and building my own couch potato portfolio – slowly but surely!
My biggest problem is indecision and paralysis. In hindsight, it’s easy to see that the crash of 2008-2009 was a glorious opportunity to buy some dividend paying stocks at all-time low prices – but like many, I kept thinking the world was ending and things would get even worse and I never pulled the trigger on some purchases. Yes, yes, yes, I know – it’s silly to try and time the market – but that’s human emotion.
Enjoying the site lots as it provides me with yet another PF opinion to consider.
S
It’s difficult to take the passive approach when everyone around me, my parents and my friends, are trading actively and enjoying the rollercoaster ride. Gloating about one’s investment gains (while ignoring the losing picks) is a favourite pastime for some of them, and nothing I say about my portfolio come close in the level excitement. I have to keep in mind that the person on the other side of my trades are very likely to be more informed than me, and being a winner once isn’t worth being a loser 5 times (since I am likelier to lose due to unnecessary transanction costs).
I’m a recent university graduate and new to the workforce and to investing. I don’t have a big enough portfolio to trade in ETFs (a certain blog confirmed this for me), so I’m in ETF mutual funds. Reflecting on my behaviour, I’d say my biggest bias is towards trusting too much – be it trusting the bank, the mutual funds, the markets, or just myself. I realize as a passive investor I shouldn’t check my investments daily or even weekly, but I think I take it too far and have a false sense of security, a sense that my investments will always be in the positive. Call it beginner’s naivety or wishful thinking.
My biggest bias is not getting tempted to go stock-picking; I’m very much in the accumulation phase, so it’s just too easy to look at alternatives to ETFs. A stock that seems solid to me drops 20% for some short-term reason, it’s hard not to be tempted to go for it. (I did that once. I think I’ll break even.)
Also, I can’t help but think that dividend stocks with DRIP discounts wind up being cheaper long-term than ETFs (ie, 10 stocks with 3% off all DRIP purchases might be a better deal than ETFs over many years). I suspect long-term I’ll be in ETFs internationally but maybe for the Canadian market I’ll be in a dozen or so stocks.
Also, it’s hard to re-balance a portfolio (or balance at all, since for the first while everything I had was in Canada) while in the accumulating phase, leading to inaction through overanalyzing (analysis-paralysis).
Finally, I also find myself analyzing where to put what – between TFSA, RRSP and non-registered, what should go where, exactly? (Your blog has given me most of the theoretical information, but now I have to work out what it means for me and my exact situation) Even worse, will that split work later on ? (ie, I might have the perfect set-up now, but when I add real estate to my portfolio, if I’m out of registered room, I don’t want to have to shuffle stuff around to have room for ZRE or a REIT).
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My strong suits though are not over-reacting, knowing that the market will fluctuate. I don’t know if I’ll rebalance when needed (wasn’t in the market in March 2009), but I’m not going to panic and sell-off, either.
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Great blog !
It is hard at times to not believe that I can beat the market as I have an undergraduate business education. Certainly this would give me a leg up on the market which includes some people who have no idea what they are doing, mutual fund and other portfolio managers who might have to invest funds in areas they dont want to just becuase they have few options (i.e. sector specific mutual fund) etc….. right?
Regardless I usually am able to stick by a more passive approach (it is hard for me to argue with low fees!)
Quite honestly, the biggest bias I have to fight is the constant barrage of information coming in from all sides (media, Internet, etc…).
I need to filter out most of that stuff, and concentrate on solid research and fundamentals when choosing to buy or sell a stock.
Even though I feel i’m getting good at that, it’s still a fight!
James, Michael, and earlier commentators,
Your comments are fascinating (and normal, neither rational nor irrational). I hope that you read my book, even if you have to buy it rather than win it from the couch potato site.
Michael, you might find why you are wise not to assume that you have a leg up because you have an undergrad degree in business. I have a Ph.D. in business yet do not think that I have a leg up. (Goldman Sachs has a leg up)
James, you might find that you are wise not to try to pick stocks and be frustrated when they plunge rather than obey his command to zoom. I think that my book would serve as a good filter for you, even if not as the filter you expected.
Happy reading…
My biggest behavioural bias is the opposite of your last post: an anti-home bias. For a variety of reasons, I tend to be reluctant about investing in Canadian markets, apart from the resource sector. Some of this is rational (e.g. lower cost ETFs abroad) and some not entirely so (e.g. dislike for the way the banking sector in Canada functions as a quasi-oligopoly). As a consequence, I largely missed out on the Canadian market’s solid performance last year.
Regarding your post, I’m not sure I entirely understand the distinction you’ve drawn between active and passive investors. Aren’t passive investors at risk of exactly the same kind of generalization (i.e. I am playing tennis against active investors and my strategy is “smarter” and will “beat” 90% of everyone else over the long haul, just by virtue of the inherent goodness of the passive strategy)?
Lots of great comments — thanks to everyone who shared their experiences, and to Prof. Statman for joining the conversation.
@Chris: You raise an interesting point. I can only speak for myself, but I don’t use a passive strategy because I’m out to beat active investors. I don’t see investing as a competition of any kind. I believe indexing is simply the best way to harness the returns that are available to anyone willing to accept the market’s inherent risks. When I buy an index fund it isn’t because I think I’ve identified some price anomaly that I can exploit. Indeed, it’s the opposite: I admit I am utterly incapable of identifying when the market might be overvalued or undervalued.
As Prof. Statman points out in his book, many people pick stocks simply because they enjoy the challenge, and that’s fine. But on some level all stock pickers must believe that they can beat the market or they wouldn’t do it. And the only way to beat the market is to identify stocks you think are mispriced. That implies that you believe you have some insight that has eluded the thousands of analysts studying that company. I think that’s a fundamentally different mindset from that of the index investor.
I don’t know if I would describe this as a bias, but the behaviour I fight against is trying to time the market. I’ll put off buying stocks for a few days if I think it’s going to go down a bit, but I invariably end up missing the minor dip. I think I’d be better off with a set schedule…the problem is sticking to it.
My biggest behavioral bias is inertia or perhaps plain old fear. I’ve set up hypothetical “couch potato” portfolios on spreadsheets, telling myself that this is the direction I need to move toward, but I am moving *very* slowly, probably because previously I had an advisor and now it’s all on me.
Not sure if it is behavioral bias but the whole idea of “hope”. Hoping the stock you bought that went down 20% will come back. So many times I have told myself to have the discipline to sell if it goes under 7% but I find myself “hoping” it will come back….
Great blog BTW set up my mother on the couch potato yield portfolio. Looking forward to watching it spin off some cash and grow! (At least I hope it will ….. ;-)
Randy,
Hope is not a cognitive error, but it is something we want very badly. See that chapter “We want hope for riches and protection from poverty” in my book “What Investors Really Want.”
My biggest behavioral bias has something to do with an intrinsic discomfort with personal finances. I am eager to learn, but at the same time, I find that finances scare me on some level. This limits the amount of focus I devote, which has a bit of a limiting factor on how I approach investing.
My biggest problem is always trying to find the perfect asset allocation. Hoping to gain that extra 1% by allocating money to an asset class that may be riskier, i.e. value investing, small cap stocks etc.
My biggest issue is not jumping in at all and waiting for too long and then I end up not doing anything.
The behaviour that I find I struggle with the most is deciding if there is any single BEST approach to investing. I’ve ruled out mutual funds because of their track record and MER’s (things I learned from great websites like this one). However, I continue to feel that a blended approach of holding long term blue chip stocks and quality bonds AND passive investments may be right for me. If nothing else, I hope that it gives me the best of both worlds….. and I am sleeping well at night!
My biggest problem is wanting to check my e-funds virtualy daily. I’m in it for the long haul, so how much it goes up or down each day shouldn’t matter, but of course I always want it to go up! Then it’s time for my montly investment and I’m wishing it had gone down… how irrational is that?!?
My biggest behavior problem is ’emotion’. Emotion is the reason where I would sell when I shouldn’t; where I would buy when I shouldn’t and vice versa. I could use the ETF, mutual fund and all the others, but it is emotion that would influence my decision. Sometimes I wish that I have no feeling, then my investment return may be better!
Timely and sage advice ! Would love to read the book
@ Cdn Couch Potato
“the only way to beat the market is to identify stocks you think are mispriced. That implies that you believe you have some insight that has eluded the thousands of analysts studying that company.”
I disagree with that statement. Investors buy and sell for a variety of reasons, one of which is the time horizon for the investor. An aging Boomer could be selling off for the income in retirement or to take profits, when a Gen X or Y comes along and stakes their position to the stock for the long term. Couldn’t they both have made a good deal?
My mom’s average cost base for her TD stock is $15. Currently analysts rate this stock as a Buy at a cost of around $75. Do you think that’s a good buy for my mom? Not likely, but for me perhaps it is a great value for a long term investment. Afterall, she likely achieved that low of a cost base after a quite a few entry points in her life as well as a stock split or two.
Buying and selling stocks is not about duping one another…that’s for the penny stock pumpers and the day-traders. Buying quality dividend growth stocks for the long term is proven to outperform any other asset class, and it’s not as difficult as you make it out to be.
Hu, interesting book … getting emotionally attached to a stock is alright if it is getting up … but not when it plumets down to nothing …ha well, someone has got to learn …
@Echo: Thanks for your comments. It’s true that individual investors have different needs, and that the transaction might be appropriate for both in terms of their life situation. But the individual’s situation does not effect the market price of the stock. If you believe that markets are largely efficient and that most stocks are fairly priced, then both parties are getting “a good deal.” But buyers and sellers of the same stock cannot both go on to beat the market.
As for the TD stock, the expected return for the stock at today’s price is exactly the same for you, your mom, and anyone else who buys it. The fact that your mom paid an average of $15 for the stock in the past has absolutely no bearing on the return of that stock going forward. This is a classic cognitive bias called the “endowment effect.” Assuming you both intend to hold the stock indefinitely, how can the same stock at the same price be good deal for one person and a bad deal for another?
Dividend-growth stocks are not an asset class. They are a subset of an asset class (equities). And there is no evidence that individual stocks with past records of dividend growth will outperform the broad equity markets over the long term. Stock selection is simply a form of active management (albeit one with low costs if trading is kept to a minimum).
I would never presume to tell dividend-growth investors that they should abandon the strategy if they are comfortable with it. Building a portfolio of dividend payers and holding them for the long-term is a perfectly valid investing strategy with a high chance of success. However, that is not the same thing as saying that it is a market-beating strategy.
Count me in for the contest! I would say my biggest bias is home bias, as I am currently only invested in Canadian Equities. A large part of this is due to the make-up of my accounts, as I am hesitant to buy U.S. equities paying dividends in my TFSA due to the fact that they are not exempt from withholding tax. I have been meaning to setup an individual RRSP at Questrade (in addition to the employee-sponsored RRSP I already have) to avoid this, however I still haven’t pulled the trigger as I keep thinking “I am fine with the Canadian stuff I hold now”.
All,
I’d be delighted to send inscribed and signed bookplates that you can place in my book, “What Investors Really Want.” Just send me an email at mstatman@scu.edu.
Meir Statman
@Cdn Couch Potato
I’m not a behavioural investment expert by any means, so my apologies if I didn’t explain myself very clearly. I’m not sure what evidence you are looking for, but over a 20 year period (1988-2008) stocks that pay dividends have outperformed the TSX by 1-2%, and stocks that GROW their dividends have outperformed the TSX by over 4%.
Here’s a fancy chart from RBC to back that up – http://dir.rbcinvestments.com/pictures/account-neil.jamison/power%20of%20dividends.pdf
I don’t believe it’s as simple as saying stock pickers are always at an unfair advantage. It didn’t take a Warren Buffet mind to know that equities were attratively priced in early 2009 which would make for a great entry point into the market. Yes, buyers were taking advantage of “the idiots” who were fearful and selling off. But that’s true for index investors too…they also needed to time the market at some point to initiate their portfolios. The entrance point in both cases is going to have a profound affect on the total returns.
I do expect to beat the market over time with this strategy, but just like with any approach it will take patience and discipline. Both active and passive investors need to overcome their emotions and stick to their strategy during good times and bad in order to achieve success.
My biggest bias is not selling when I should (both to dump a loss and realize a gain)
@Echo: The RBC marketing material doesn’t explain its methodology, so it’s impossible to know how they arrived at these numbers. However, there is an obvious flaw here, and in most claims that dividend-growth strategies beat the market. The fact that a stock raised its dividends for many years can only known after those increases have already occurred. So anyone screening stocks in 1988 would have had no way of knowing which ones would go on to raise their dividends over the next 20 years, and therefore outperform the market. The market-beating stocks can only be identified after the fact, which is useless information, except to marketers.
Have a look at the funds that screen stocks based on dividend growth and yield, including CDZ and XDV in Canada and the WisdomTree ETFs in the US. The results are underwhelming to say the least.
To say that it was obvious that early 2009 was a good entry point is classic hindsight bias. Everyone is buying gold now because it is flying high, but you can be sure that if and when its price plummets, everyone will say it was “obvious” that it was a bubble. Obvious, yes, but only in hindsight.
Passive investors do not (or should not) try to time their entry points in the market. Yes, entry points will have a large effect in the long run, but whether your timing was good or bad cannot possibly be known in advance.
@Cdn Couch Potato
“everyone is buying gold because it is flying high”
The fact that gold is at a record high is precisely why I wouldn’t invest in gold right now (not that I would ever) and is exactly the opposite of the point I made about equities in 2009. The entry point was obvious to me at the time, so I entered. Not at the exact low of March 2009, but around the end of May. Again, I am no expert.
You can’t cherry pick something like CDZ and say the overall results are underwhelming when they only have 4 years of history behind them (including one of the worst crashes in history). The market in general has been pretty underwhelming if you only look back 4 years.
Yes dividends are not guaranteed, but if a company has paid them for a century (Cdn Banks) and if a company has increased them for 37 consecutive years (Fortis), then one can reasonable assume that they will continue to do so.
True you cannot perfectly time the market, but one can make sound observations about when something is value priced and when it’s not. Nobody has a crystal ball, we all have to rely on past information to make informed decisions.
Why do you personally invest in the market (even passively)? Isn’t it because the market historically has provided superior returns over other investments?
My greatest behavioral flaw when it comes to investing is impatience. I want to see progress, quickly. I’m a results-oriented kinda guy. I like to see metrics, go up, rapidly.
With dividend investing as my primarly investing strategy, I want to see that passive income increasing quickly, dividends compounding, not slowly. It’s difficult for me to watch the slow progress as dividends accumulate. While I strongly believe in my strategy it doesn’t make it any less difficult sometimes to execute. With index investing as my secondary strategy (in my RRSP) it’s tough to wait for the market to correct itself after a prolonged trough (refer to 2008-2009). I’ve had temptations in the past to sell some equity ETFs when Mr. Market decides to take his profits. Instead, for both approaches, I’ve learned and I’m still learning to hold the line when things go south. When that happens, I always need to remind myself I’m buying equities cheaply, whether it be stocks or ETFs.
If I can learn to improve my patience with investing, it won’t really matter what Mr. Market does in the future.
Have a good weeekend Dan!
Very interesting conversation and post. In terms of behavioural bias, I have many. But the one that bothers me the most is my never-ending and ellusive ‘search for perfection’. Prior to being turned onto couch potato investing, I would spent countless hours trying to figure out which sector or which stock would do well, and try to find the ‘perfect’ entry point. My portfolio reflected the misguided nature of my quest. However, discovering index investing didn’t solve my problem. Like others who’ve commented, my search for perfection then shifted into asset allocation and entry points: Should I have 22.5% in CDN Equities or only 20%? What about XRE – can’t leave that out! Should I move my money in over 12 months or all at once?
I’ve realized I need clear cut rules about investing – not to maximize returns – but to stop myself from being so obsessed by small details. First, I’ve decided to pretend that sector ETFs and commodity ETFs simply don’t exist. I don’t read about them (any longer), I don’t track them (any longer). Only broad-based Equity index funds exist in my world. Second, currency hedging doesn’t exist either. There is no such thing. Third, I add/rebalance positions on a schedule that matches my contributions – in my case quarterly. I no longer add cash and wait for the right time to buy in.
One other bias I have is that I’ve recognized my need to follow individual companies. While I think it’s very smart to invest in an index, I really like buying a company, following it’s reports, and paying attention to it’s progress. I do this by keeping a portion of my portfolio in dividend-growth stocks. In reality, I’m not sure this is smart. I’d probably be better served by having a 100% couch potato portfolio. But, I know me. I’m not disciplined enough. This ‘active’ part of my portfolio gets me more involved and satistifies something in me that passive investing doesn’t. I certainly don’t think I’m going to beat the market with my choices – although it would be nice! – but I’m doing it as a way of protecting me from myself.
Regarding the discussion of ‘beating the markets’ and dividend growth investing, I think it’s easy to lose sight as to why were investing in the first place – at least most of us. When I meet with my financial planner and she walks me through my retirement needs and my time frame, my family is going to be quite comfortable with a 7% rate of return. I actually don’t have to beat the market I don’t think. Just hanging around with the market should be fine.
I was under the impression that the evidence for the superiority of passive investing generally indicates the following: over (i) a long enough period of time, (ii) passive investing will beat a large percentage of active investors (80%-90%; the exact number is irrelevant), (iii) when both sets of investors are investing in the *same* market.
Items (i) and (iii) are critical, and shouldn’t be overlooked. For example, over the last 10 years, investing in corporate bonds (passive or active) has outperformed passive investing in the “market” as defined by the S&P 500. This may or may not continue, depending on one’s views about past performance being a predictor of future performance, one’s views about future economic growth in developed economies, and a variety of other factors. Even if this did continue, it wouldn’t violate the thesis about the advantages of passive investing, because (iii) is not satisfied. These are not the same markets.
Likewise, it is perfectly possible for dividend stocks having particular characteristics (passively or actively managed) to outperform passive investing in the “market” over the long term. This does not violate the thesis about the advantages of passive investing, because dividend stocks having a given set of characteristics are a sub market that is different than the “market” (however the latter is defined, S&P 500, some mix of the Russell 2000 and bonds, etc.). Like Echo, I was under the impression that this has been true for the last number of years, given that the 10 year annualized gain of the S&P 500 is less than 1%, and it would not have required any great skill to choose dividend payers paying more than that (again, actively or passively using some screen). But it really doesn’t matter either way. My main point is that your choice of “market” or sub-market matters, and it’s important not to overstate the passive thesis. It is strong enough on its own.
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