On Magical Thinking And Investing*

February 28, 2012

On Magical Thinking And Investing

Readers of my books often ask: “Given that the evidence against active management and for indexing (or passive investing) is so overwhelming, why do the majority of investors keep playing a loser’s game?” I offer some explanations for this phenomenon.

First, the education system has failed the public. Unless an investor obtains an MBA in finance, it’s likely he or she hasn’t taken a single course in capital markets theory. The result is that investors get their “knowledge” about investing from the very people—Wall Street and the financial media—who don’t have their interests at heart because the winning strategy for them is for investors to play the game of active investing. Second, despite the importance of the issue, the public seems unwilling to invest the time and effort to overcome the failings of the education system. Instead of reading books like mine or John Bogle’s or William Bernstein’s, they would rather watch CNBC—to hear some guru’s forecast—or some reality TV show.

The third explanation is what we might call the Lake Wobegon effect: the need and/or desire to be above average. This seems especially true of high-net-worth people, especially when it comes to investments. Wall Street preys on that need. You hear the repeated lie that goes something like this: “Indexing is a good strategy, but it gets you average returns. You don’t want to be average. We can help you do better than that.” The truth is that indexing gets you market returns. And because it does so with lower costs and greater tax efficiency, by definition, you earn above-average returns—as long as you have the discipline to stay the course. This is about the only guarantee there is in investing.

Ignoring The Evidence
Why do people ignore all the evidence? Why do so many investors continue to play a game that while it’s possible to win, the odds are so poor it’s simply not prudent to try? Kathryn Schulz provides us with some fascinating insights that help explain this phenomenon, one that allows Wall Street to transfer tens of billions every year from the pockets of investors to its own pocket.

Schulz is the author of the book “Being Wrong.” She explains that most of us go through life assuming that “we are basically right, basically all the time, about basically everything.” And that “our indiscriminate enjoyment of being right is matched by an almost equally indiscriminate feeling that we are right. Occasionally, this feeling spills into the foreground, as we … make predictions or place bets [or make investments].” She goes on to explain that often this confidence is justified as we “navigate day-to-day life fairly well …” This suggests that we’re right about most things. Schulz’s book, however, is about being wrong and what happens when our convictions collapse around us—we often feel foolish and ashamed as error is often associated with “ignorance … psychopathology, and moral degeneracy.”

Schulz noted that we tend to view errors as things that happen to others, yet somehow we feel that it is implausible that they’ll happen to us. She believes this is because “our beliefs are inextricable from our identities,” and “we’re so emotionally invested in our beliefs that we are unable or unwilling to recognize them as anything but the inviolate truth.” She notes that “ . . . we have a habit of falling in love with our beliefs once we have formed them. [Such as ‘active management is the winner’s game’].” And that explains why “being wrong can so easily wound our sense of self.” It explains why we experience cognitive dissonance—the uncomfortable feeling and/or anxiety we feel when someone disproves a long-held belief. It also explains why we ignore evidence, even when it is compelling, and why we resist change.



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