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« Make Sure You Buy and Are Not Sold | Main | CQT 2010: Is That It? »
Sunday
Feb212010

The Lake Wobegone Effect on Investors

Garrison Keillor introduced us to the mythical town of Lake Wobegone, Minnesota, a place "where all the women are strong, all the men are good-looking, and all of the children are above average."  Of course all of us can identify with Lake Wobegone somewhat.  It may be possible that not all of our women are strong; perhaps not everyone of our men are good-looking; but certainly all of our children are above average.  It is also likely that Lake Wobegonians consider themselves above average drivers, as well as above average investors. In fact, when asked, almost everyone says that they are "above average" drivers, and many also suspect that they are above average investors.  The rub is proving that claim, and it is very hard to prove.

In Poor Richard's Almanac Ben Franklin once recorded "There are three things extremely hard: steel, a diamond, and to know one's self."  Numerous academic studies have proven the truth of Ben's observation.  Our ability to accurately assess ourselves (our academic ability, our character, our leadership skills, even our ability to respond well under pressure) greatly affects the choices we make in life.  For example, a student chooses a major in college because they believe they will do better in that course of study than they would in some other discipline.  A young violinist applies to a prestigious music school because they believe that they have the gift to excel with the violin.  Or, we choose to invest in a particular stock because we believe we have the ability to pick winning stocks.  How we assess our own abilities affects virtually every choice we make in life.  The problem is that we are notoriously unable to accurately assess ourselves.  One study found that of one million high school seniors, 70% thought that they had above average leadership skills; only 2% rated their leadership skills below average (College Board, 1976-1977).  College professors were little different as 94% of them in another study (Cross, 1977) freely admitted that they did above average work compared to their peers.

 People also tend to overestimate their ability to bring about future desirable events. Lawyers are not immune to the "Lake Wobegone" effect as they often overestimate their ability to win the cases they about to take to trial (Lofuts & Wagenaar, 1988).  And numerous studies have shown that stock pickers think that the stocks they buy will more likely be winners than those bought by the "average" investors (Odean, 1988).  All of this research simply points to the difficulty of following the advice Polonius gave to his son, Laertes, in Shakespeare's Hamlet:" This above all, to thine ownself be true."  It is not that we do not want to be true to ourselves; it may be that we don't know how to be true to ourselves.  We are impacted by so many influences, sometimes without our conscious knowledge,  that it is not surprising that we do not have the objectivity to accurately assess ourselves. 

In the arena of investing, we see similar factors at work.  We all like to think of ourselves as just a bit smarter, a little bit savvier than the average Joe.  This idea may get reinforced from time to time during periods of rising markets when everyone's portfolio is going up in value.  No doubt many of us have confused that phenomenon with investing acumen.  But the market eventually does something unpredictable; and, if we are teachable,  we realize the limitation of our knowledge.   As investors we also get duped from time to time by the concept of "recency."  This is the mistaken belief that recent conditions will continue into the future.  (Home prices always go up. . . don't they?) This accounts for so many investing at the tops of markets, and selling at the bottom.

I believe investing wisdom begins when we acknowledge what we do not know.  I now realize that I do not know where the market will be in a month, or a year.  I do not know what stock, or two stocks, or ten stocks to buy to insure my investing success.  There may be the individual with the skills set, or tenacity, or insight, or (dare I say it) the luck to make such judgements, but I have neither the time nor aptitude for such (and the ones that do are few and far between).  I know that there is much that I do not know.  I also know that there is much that investment "experts" do not know.  I know that less than 15% of all mutual fund managers will beat their market benchmarks in any particular year, and the ones that do so this year will likely fail to do so next.  And remember, these are men and women who devote their lifelong careers to investing and are paid handsomely for doing so.  I have come to the realization that I am likely no better than an average or (gulp) below average investor.  If you recognize a little of yourself in any of these thoughts, whatever shall we do?

Once one acknowledges their investing limitations, and the fact that most experts fare little better, index mutual funds and Exchange Traded Funds (ETFs) begin to look like much wiser investments.  With these low cost investment options one can easily construct a well diversified portfolio and their use is recommended by many successful investment experts like John Bogle of Vanguard fame. Experience has shown that the "average" investor is more likely to find long term investment success by using low cost investment vehicles, like index funds and ETFs, and a routine investment program where costs are reduced through dollar-cost averaging.  The less the average investor trades and/or dickers with his investments, the lower will be his cost and the higher will likely be his returns.  The path to this discovery for many is littered with frustration, and lost opportunities, not to mention lost dollars!

I believe the way for a less than average investor to become an above average investor begins by their acknowleging that they may actually be no better than average.  Once pride is out of the way and we realize that for most "slow and steady" leads to investment success, the plan I outline above will begin to make sense.  That plan is much like the portfolios Scott Burns, a noted investment writer, and John Bogle recommend; and they are two of the smartest investment minds that I have read.  Just google Scott Burns and you will find his explanation of his Couch Potato portfolio, as well as his other simple portfolios.   I am convinced that over the long term we can become "above average" investors using this simple approach and just pretending to be below average.  We may not experience the thrill and adrenalin rush of the day traders, but then they are seldom average!

 

Fly/Drive Safely

22 February, 2010

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