Behavioral Errors Hurt Your Returns
Daniel Kahneman is a senior scholar at Princeton University’s Woodrow Wilson School of Public and International Affairs and the 2002 winner of the Nobel Memorial Prize in Economic Sciences. His book “Thinking, Fast and Slow” (Farrar, Straus and Giroux) was published last fall. I spoke with him recently about the impact of behavioral errors on investment performance.
—Charles Rotblut, CFA
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Charles Rotblut (CR): You opined as we sat down that individual investors should use index funds instead of picking their own stocks. Could you explain why?
Daniel Kahneman (DK): Well, there is research for that. The research I have in mind was done by my former student, Terry Odean, who is now a professor of finance at the University of California–Berkeley. He did a study of the decisions of individual investors who sell a stock and buy a stock, which means that they are not selling it for liquidity; they’re selling it because they believe the stock they sell is inferior to the stock they buy. There is no other reason.
Now, when you wait a year, and you look at the value, on average, of the stock that individual investors sell and the stock they buy, then you get a difference of 3.5%, roughly, almost 4%. So that means every action the individual investor takes has negative expected value. On average, they lose, and the more ideas they have, the more they lose. Women do better than men because they churn their accounts less. The real enemies of good returns are churning and lack of diversification. Individual investors fall for both of those. So that would be my advice: Avoid churning and avoid making decisions, because individual investors are really, by and large, not equipped to make the decisions.
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