Swedroe: Admit Your Investing Mistakes

There are a number of explanations for why many individual investors ignore the overwhelming body of academic evidence and continue to play the loser’s game that is active management.

Briefly, three of those reasons are:

• An education system that has failed the public. Unless an investor obtains an MBA in finance, it’s unlikely that person has taken even a single course about capital markets theory. Instead, investors rely on “knowledge” from the very people—Wall Street and the financial media—who have a vested interest in active management.
• Despite the importance of this issue, the public seems generally unwilling to invest the time and effort to overcome the failings of the education system.
• The need or desire to be “above average,” an occurrence we might call the “Lake Wobegon effect.”

Today we’ll discuss a fourth explanation for why more investors don’t pursue a passive-investment strategy.

Passive Wall Of Resistance

The authors of the wonderful book “Mistakes Were Made (But Not by Me),” social psychologists Carol Tavris and Elliot Aronson, provide us with this reason: “Most people, when directly confronted with proof that they are wrong, don’t change their point of view or course of action but justify it even more tenaciously. Politicians, of course, offer the most visible, and often tragic, examples of this practice …We even stay in an unhappy relationship or merely one that is going nowhere because, after all, we invested so much time it making it work.”

Tavris and Aronson explain: “Self-justification has costs and benefits. By itself it’s not necessarily a bad thing. It lets us sleep at night. Without it we would prolong the awful pangs of embarrassment. We would torture ourselves with regret over the road not taken or over how badly we navigated the road we did take. We would agonize in the aftermath of almost every decision… Yet mindless self-justification, like quicksand, can draw us deeper into disaster. It blocks our ability to even see our errors, let alone correct them. It distorts reality, keeping us from getting all the information we need and assessing issues clearly.”

Make Mistake, Repeat

Investors, both individuals and institutions, who rely on the past performance of active managers and rankings like those from Morningstar, hire managers but eventually fire most of them, and then repeat the process. They do so without ever asking: “What am I doing differently this time in the selection process so I don’t repeat the mistake I made last time?”

In a triumph of self-justification, they end up doing what Einstein described as the definition of insanity—doing the same thing over again and expecting a different outcome.

Tavris and Aronson note that “None of us can live without making blunders. But we do have the ability to say: ‘This is not working out here. This is not making sense.’ To err is human, but humans then have a choice between covering up or fessing up. The choice is crucial to what we do next. We are forever being told that we should learn from our mistakes, but how can we learn unless we first admit we make any?”

Hard To Say You Were Wrong

Unfortunately, admitting mistakes is a difficult hurdle for many. A great example of this behavioral problem is the clever insight of Lord Molson (a 20^th-century British politician) into his own behavior: “I will look at any additional evidence to confirm the opinion to which I have already come.” This leads to the well-documented behavioral finance problem of confirmation bias.

Perhaps the saddest part is that investors miss out on just how freeing it can be to admit a mistake. Tavris and Aronson told a story about a friend who went to traffic school and heard excuse after excuse from drivers ticketed for running red lights or making illegal U-turns. This friend became so fed up with it, he stood in front of the judge when it was his turn and said, “I didn’t stop at a stop sign. I was entirely wrong and I got caught.” The entire room burst into applause.

If you’ve hired and fired fund managers and/or advisors advocating active strategies, or have been using active strategies on your own and have underperformed appropriate risk-adjusted benchmarks, perhaps it’s time you fessed up?

Larry Swedroe is the director of research for the BAM Alliance, a community of more than 150 independent registered investment advisors throughout the country.