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Enrich Your Future 21: Think You Can Beat the Market? Think Again
12th December 2024 • My Worst Investment Ever Podcast • Andrew Stotz
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In this episode of Enrich Your Future, Andrew and Larry Swedroe discuss Larry’s new book, Enrich Your Future: The Keys to Successful Investing. In this series, they discuss Chapter 21: You Can’t Handle the Truth.

LEARNING: Overconfidence leads to poor investment decisions. Measure your returns against benchmarks.

 

“If you think you can forecast the future better than others, you’re going to ignore risks that you shouldn’t ignore because you’ll treat the unlikely as possible.”
Larry Swedroe

 

In this episode of Enrich Your Future, Andrew and Larry Swedroe discuss Larry’s new book, Enrich Your Future: The Keys to Successful Investing. The book is a collection of stories that Larry has developed over 30 years as the head of financial and economic research at Buckingham Wealth Partners to help investors. You can learn more about Larry’s Worst Investment Ever story on Ep645: Beware of Idiosyncratic Risks.

Larry deeply understands the world of academic research and investing, especially risk. Today, Andrew and Larry discuss Chapter 21: You Can’t Handle the Truth.

Chapter 21: You Can’t Handle the Truth

In this chapter, Larry discusses how investors delude themselves about their skills and performance, leading to persistent and costly investment mistakes.

The deluded investor

According to Larry, evidence from the field of behavioral finance suggests that investors persist in deluding themselves about their skills and performance. This persistent self-deception leads to costly investment mistakes, emphasizing the need for continuous vigilance in investment decisions.

Larry quotes a New York Times article in which professors Richard Thaler and Robert Shiller noted that individual investors and money managers persist in believing that they are endowed with more and better information than others and can profit by picking stocks. This insight helps explain why individual investors think they can:

  • Pick stocks that will outperform the market.
  • Time the market, so they’re in it when it’s rising and out of it when it’s falling.
  • Identify the few active managers who will beat their respective benchmarks.

The overconfident investor

Larry adds that even when individuals acknowledge the difficulty of beating the market, they are buoyed by the hope of success. He quotes noted economist Peter Bernstein: “Active management is extraordinarily difficult because there are so many knowledgeable investors and information does move so fast. The market is hard to beat. There are a lot of smart people trying to do the same thing. Nobody’s saying that it’s easy. But possible? Yes.”

This slim possibility keeps hope alive. Overconfidence, fueled by this hope, leads investors to believe they will be among the few who succeed.

Why investors spend so much time and money on actively managed mutual funds

Larry also examined another study, Positive Illusions and Forecasting Errors in Mutual Fund Investment Decisions, which sought to find out why investors spend so much time and money on actively managed mutual funds despite passively managed index funds outperforming the vast majority of these funds.

The authors concluded that the reason was that investors deluded themselves. They found that most participants had consistently overestimated their investments’ future and past performance.

In fact, more than a third who believed they had beaten the market had actually underperformed by at least 5 percent, and at least a fourth lagged by at least 15 percent. Biases such as this contribute to suboptimal investment decisions.

You are better off accepting market returns

While Larry agrees that it is undoubtedly possible for investors to outperform the market, the evidence demonstrates that the vast majority would be better off aligning their expectations with reality and simply accepting market returns.

At the very least, investors should know the odds of outperforming. Unfortunately, most investors delude themselves about those odds, highlighting the necessity of aligning expectations with reality.

One reason, Larry says, might be that investors are unaware of the evidence. Another is that they don’t know their own track records. Larry notes that this self-delusion helps explain why investors exhibit the common human trait of overconfidence.

Most people want to believe they are above average. Thus, the disconnect investors have between reality and illusion persists.

Always measure your investment returns

In conclusion, Larry advises investors to measure their investment returns and compare them to appropriate benchmarks. Doing so will force you to confront reality rather than allow an illusion to undermine your ability to achieve your financial objectives.

Further reading

  1. Jason Zweig, Your Money & Your Brain, (Simon & Schuster 2007).
  2. Jonathan Fuerbringer, “Why Both Bulls and Bears Can Act So Bird-Brained,” New York Times, March 30, 1997.
  3. Jonathan Burton, Investment Titans, (McGraw-Hill, 2000).
  4. Money, “Did You Beat the Market?” (January 1, 2000).
  5. Don A. Moore, Terri R. Kurtzberg, Craig R. Fox, and Max H. Bazerman, “Positive Illusions and Forecasting Errors in Mutual Fund Investment Decisions,” Harvard Business School Working Paper.
  6. Markus Glaser and Martin Weber, “Why Inexperienced Investors Do Not Learn: They Don’t Know Their Past Portfolio Performance,” (July 21, 2007).

Did you miss out on the previous chapters? Check them out:

Part I: How Markets Work: How Security Prices are Determined and Why It’s So Difficult to Outperform

Part II: Strategic Portfolio Decisions

About Larry Swedroe

Larry Swedroe was head of financial and economic research at Buckingham Wealth Partners. Since joining the firm in 1996, Larry has spent his time, talent, and energy educating investors on the benefits of evidence-based investing with an enthusiasm few can match.

Larry was among the first authors to publish a book that explained the science of investing in layman’s terms, “The Only Guide to a Winning Investment Strategy You’ll Ever Need.” He has authored or co-authored 18 books.

Larry’s dedication to helping others has made him a sought-after national speaker. He has made appearances on national television on various outlets.

Larry is a prolific writer, regularly contributing to multiple outlets, including AlphaArchitect, Advisor Perspectives, and Wealth Management.

 

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Andrew Stotz:

tell fellow risk takers, this is your worst podcast host, Andrew Stotz from a Stotz Academy, continuing my discussion with Larry swedro, who for three decades was the head of Research at Buckingham wealth partners. You can learn more about his story in episode 645, Larry stands out because he bridges both the academic research world and practical investing. Today we are diving into the chapter from his recent book, enrich your future is the key to successful investing. And this is chapter 21 and the title is, you can't handle the truth. Larry, take it away.

Larry Swedroe:

Yeah. So we've talked before in previous sessions, I think, more than once, about the all too human behavior of overconfidence or bias that causes us to think we're better than average at all kinds of things. And this is the problem here is not only that we think we're overconfident, but we have the ability to delude ourselves about our ability, and that leads to persistent errors, like taking more risk than we should take. You know, thinking we can estimate the odds of a recession or a bear market better leads us to concentrate assets, because we can pick the best stocks or pick the best money manager, because we could do that, although all the evidence says you can't, and the institutions can't, as we've discussed. And my favorite story about this, which I began this chapter with, is there. It's well known. One of the most famous studies was done in Sweden about drivers, and they were asked, Are you a better than average driver? And something like typically, when people are asked that type of question, 80 to 90% say they're better than average, which, of course, is impossible, right? Only 50% can be better than average, you know. But my favorite story about this, to show how we can delude ourselves, and then we'll talk about how that relates to investing, is this. So in 1965 50 drivers were asked to rate their skill and ability the last time they were behind the wheel, and about two thirds said that they were at least as competent as usual. Many even described their skills as exceptionally good. What is particularly interesting about this study done by two psychologists was that the participants they chose had ended up in an ambulance headed for the hospital. Based on that was the last time they were driving and police reports showed that almost 70% of those that were in those ambulances were responsible for the crashes, and almost 60% of them had two past performances, a similar number that totaled their cars, and almost 50% faced criminal charges. Yet, two thirds of them said they were at least as competent as usual, and many were better than average. If that's not evidence that we can self be, you know, delude ourselves. I don't know what more you could say.

Andrew Stotz:

Yeah. I mean, that's I just can imagine them saying it was just bad luck. It was just bad luck.

Larry Swedroe:

Yeah, you know, and you know. So that's the problem. So you know, the problem with being overconfident is it, as I mentioned, can lead you to think you can outperform the market and therefore trade a lot. And the evidence we know, as we've discussed before, is the more you trade, the worse you do also you're going to concentrate risks when only 4% of all the stocks account for 100% of the risk premium, as we've talked about, what are the odds you can identify that 4% when we know the vast majority of professional investors with far more skill spending 100% of their time on the effort failed with great persistence, and only about 2% today of actively managed mutual fund managers outperform on a risk adjusted basis with any statistical significance, And that's even before taxes, let

Andrew Stotz:

me just ask. The ability

Larry Swedroe:

to delude ourselves, we know it's possible to beat the market. Is it likely? The evidence says no.

Andrew Stotz:

Can I just ask you know, is it? Is it only in this space of investing or maybe driving that you know that people are overconfident? Because you would think. So if people are overconfident to this level in their lives, they just be falling off of buildings everywhere, because they would be overconfident in their ability to balance, and they would be overconfident in their ability to get across the street. It's just like people would be dying everywhere or causing huge problems. But what it is, I mean, obviously investing is, you know, super competitive, as you've explained in the past. But I'm just curious, is there another mechanism that's offsetting the overconfidence in other parts of our lives? Or how does that work? I

Larry Swedroe:

think the simple answer is common sense. So Andrew, if you're an average person, and I ask you, are you a better than average driver? The odds are pretty good, 80 90% you're likely to say you're better than average. Now let's say you're out driving. You've had a couple of drinks with dinner with some friends. You're not drunk or anything, but it's a monsoon rain, as happens in Thailand, pouring down, and highway you're on has a speed limit of, say, 70 miles an hour, but it's pouring rain. Are you likely to try and speed that? Your common sense would probably override that, and, say, or to keep a little extra distance slow down a little bit, so common sense overrides that, but overconfidence one of the reasons I believe, and I'm not a trained psychologist, why we're overconfident, it's actually healthy for our egos. Imagine Andrew, if you woke up in the morning, looked in the mirror and said, I'm dumb, ugly, stupid, and nobody likes me, the suicide rate would be through the roof if people did that. So it's good that we, 80 to 90% of the people, think they're better looking than average, they're smarter than average. They friends like them more than the average person, and they're a better than average lover. I mean, all these things people have been tested on, and 80 to 90% is the typical answer. But that doesn't cause them any harm. It actually makes them feel good about themselves. The problem is, when it comes to investing, if you think you can forecast the future better than others, you're going to ignore risks that you shouldn't ignore, because you'll treat the unlikely as if it's impossible. You're likely to concentrate your risk because you can pick which of the stocks are going to win, obviously, and the evidence shows how bad we are at that. And as I mentioned earlier, we really delude ourselves to protect our egos. Again, I'm not a trained psychologist, but my belief is we delude ourselves to make ourselves feel good. So let me give you another example from a study done by Money Magazine, a US publication on more than 500 individual investors. Now the Dow have returned that year 20 let's see the Dow returned 46% over that prior 12 months, 1/3 of the investors stated that their portfolio had returned between 13 and 20 another third said they earned between 21 and 28 and about 25% said they beat 29 4% admitted they had no idea what they did. All right, while the S, P returned 46% and it outperformed more than three quarters of all the investors. And we know, if you ask people, did you beat the market, most of them will say they did so, right? That's the problem. I'll give you one other study here. 30 30% in one study done, 30% considered themselves above average. And those investors, when their actual performance was reviewed, they overestimated their own performance by almost 12% a year and 5% believe they had experienced negative returns, when actually it was fully a quarter of them, or 25% had negative returns. And of course, the markets go up, right? It's really difficult. The investors believe that they're in charge. They have a great ability to delude themselves about their ability, and that allows them to continue to make these mistakes, because they can't admit they're wrong. Their egos won't let them, and they probably don't even look at the data to compare, because it would create. Eight damage for their egos. Yeah. I

Andrew Stotz:

mean, the title of that research was great. It's why inexperienced investors do not learn. They do not know their past portfolio performance. Yeah. I mean, people just don't know

Larry Swedroe:

it's and I think it's, they don't want to know, yeah, at least for some people, anyway,

Andrew Stotz:

for some, I mean, it's hard, it's hard to, I mean, if you're not getting it through an app that, you know, provides you the exact information you got to try to do that in Excel, you know, very it's not easy for some people.

Larry Swedroe:

Here's the best story about that. There was a group of ladies called the Beardstown ladies. You may know that story. I

Andrew Stotz:

bought that book when I was young. I was like, wow, this is the key.

Larry Swedroe:

Yeah, this you were one of the suckers who bought that book. They were touted and millions of people books was a best seller. Sold far more than any of my books. Unfortunately, for the people who bought the books and should have been reading mine instead, but they reported these spectacular returns until and well after the book was published, like years later, even the publisher wasn't smart enough to maybe ought to check, because what are these odds that these ladies who had zero experience in investing could outperform It was possible. It could have been random luck, but without that, they certainly weren't skilled in terms of having more investment knowledge than the professionals. What were the odds they would have outperformed by that much? The problem was that the ladies were counting as return their monthly contributions to the Investment Club. So if they, if there were, I'm making this up, if there were 12 ladies, and they each put in 100 bucks every month. That $1,200 they showed as a return, not as an increase in their cost basis. And that's how they got these spectacular when the actual data was published,

Andrew Stotz:

returns, how could the book publisher not have noticed that, or asked to check? They

Larry Swedroe:

didn't ask. They sort of asked for an audit, right? Yeah, prove that you actually had these great returns. People want to delude themselves so they believe in these fanciful tales.

Andrew Stotz:

You know, you talked in, you talked at the end earlier, about the people who feel in charge, and here you're talking about how they're the worst.

Larry Swedroe:

Yeah, that's, I think. You know, there's good studies, one by Brad bar and barber and Terence odean, called boys will be boys. And it looked at a gender study, and it found that men and women are equally bad at stock picking. They both the stocks they buy go on to underperform after they buy them, and they stocks they sell go on to outperform after they sell them. That means they're being exploited. Somebody's on the other side of those trades. Obviously, it's a zero sum game. It's institutional investors who are a lot more sophisticated. They're exploiting the naive retail investors on average. The problem is that there aren't enough of these naive retail investors. So while they outperform the stock picks of the institutions, roughly about 70 basis points from a study Russ worm is did about 20 years ago, their costs were like one, you know, 220, basis points in total, including their expense ratio trading costs, the cost of sitting on cash, which underperforms the market over the long term, and so you end up losing significantly. There just aren't enough of these naive investors. So you know that's the problem. You know that that we have, there's they think they can outperform. But here's the the the new month of the story, while women are just as bad at picking stocks as men, women actually outperform men, and the reason was simple, they had less over confidence the men, I call it the testosterone factor, think they're much better than they actually are, and that leads them to trade a lot because they're all and the more they traded, the worse they did. And of course, the women tend not to be, you know, have as bigger egos as the men. They don't have as much testosterone, maybe, and they just are more cautious and don't trade as much. They don't think they're much smarter than the market. And here's the other thing, married women do worse than single women, and married men do better than single men, because each side has some. Somebody either pulling them down or preventing them from doing as bad as they would otherwise. And just,

Andrew Stotz:

I thought we would wrap it up, just if you could revisit the S and P dow jones indices statistics that you have in here, I can later update some stuff in the post about 2023 but just to give a picture of like, the percent of funds that outperform you have it in your possible comma, not likely section,

Larry Swedroe:

right? So the annual S, P report from SPIVA, which is the active versus passive measurements, reported that over the 20 year period, ending in 2022 95% of large cap funds, 94% of mid cap and small cap funds underperform their s, p indices. Now that's before taxes, so if you you know, if you're talking about somewhere between five and 6% are outperforming before taxes, it's probably more like half of that after taxes. And I don't know about you, but those kind of odds are something I wouldn't try to overcome, especially when the average investor has far less skill knowledge training than the mutual fund.

Andrew Stotz:

Yeah, and at the end of this, you say it's important to measure your investment returns and also compare them to appropriate benchmarks. Doing so will force you to confront reality, rather than allow an illusion to undermine your ability to achieve your financial objectives. And I think that really is a great way to wrap it up to say, you know you must, you must understand your exact performance, and that without that type of you know information, you're just going to be deluding yourself, as we've learned from this chapter. Yeah.

Larry Swedroe:

And one of the things we've talked about before, Andrew, I know you've pointed out to your listeners, portfolio visualizer as a regression tool, so allows you to look at if you've chosen a mutual fund to see if it's actually generating alpha on a risk adjusted basis, or that they just beat the market because they happen to own, say, small value stocks in 2013, or 16, when small value dramatically outperformed, right? And if they're underperforming the market, because they're in small value doesn't mean that they were poor stock pickers, it just means that those asset classes in that particular period underperformed. They may have even outperformed a risk adjusted benchmark. So that's a really good tool for people to learn to use,

Andrew Stotz:

and I'm glad I used it when you showed me, because I did a screenshot, a video, and I showed buffet Berkshire versus the index, S, p5, 100 over 20 years. I recently went back to to redo that, and they changed the policy where you only get 10 years of free data. So that's fair, but maybe we need to get get them to be a sponsor of the show. Huh?

Larry Swedroe:

There you go.

Andrew Stotz:

So Larry, I want to thank you for another great discussion about creating, growing and protecting our wealth, and I'm looking forward to the next chapter, 22 which is some risks are not worth taking. For listeners out there who want to keep up with all that Larry's doing, follow him on X or Twitter at Larry swedro, and also you can find him on LinkedIn and he responds, this is your worst podcast host, Andrew Stotz, saying, I'll see you on the upside. You.

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