Behavioral Errors Hurt Your Returns

by Daniel Kahneman

Behavioral Errors Hurt Your Returns Splash image

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

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?

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Daniel Kahneman is a senior scholar at Princeton University’s Woodrow Wilson School of Public and International Affairs and author of “Thinking, Fast and Slow” (Farrar, Straus and Giroux, 2011).


Discussion

Orlan Gaeddert from California posted about 1 year ago:

“Thinking, Fast and Slow” is a splendid book, very readable. Seems to me, however,that Kahneman has a quite superficial understanding of investing and investors. In any event, I found no grist there for my mill. As always, caveat emptor!


Paul Hopler from Virginia posted about 1 year ago:

There are other reasons for selling one stock and buying another. We are constantly reminded to re-balance, assure a good mix of sectors, obtain some foreign, mix of large and small companies, growth and value companies, sell a stock that has a low "rating" and assure a stock is not too prevalent. In most cases we sell a stock we really like and buy an inferior one to improve asset allocation as the author suggest. This reduces the accusation of poor choices.


Tim Burland from Wisconsin posted about 1 year ago:

The advice to invest in index funds rather than individual stocks seems like a reasonable approach to avoiding behavioral investing errors, but it may not be the best advice to achieve the other key target, minimizing costs. Let's say the average annual expense for mutual funds is 1%, and for index funds 0.2%; and a stock transaction is $8 ($16 round-trip buy-sell). Consider the holding period for mutual funds and index funds to be indefinite, and then consider three types of stock investor: (i) AAII Model Portfolio, currently with 27 stocks; (ii) A typical investor as cited in the related Steven Sears article holding 27 stocks for an average 3.27-year holding period (turnover ratio 30.58%); and (iii) An investor who holds 27 stocks for the five-year average typical of a market cycle (20% turnover ratio). For a $200,000 portfolio (perhaps the smallest you'd want for holding all 27 stocks in the AAII portfolio), five-year ongoing costs would then be:

Mutual Funds $10,000 (yikes...)
Index Funds $ 2,000 (much better)
27 Individual Stocks (including $20 for Kahneman's book):
Annual turnover 35.8% $ 681
Annual turnover 20.0% $ 452
AAII Model portfolio $ 948 (116 $8 transactions 2007-2011)

Investors with smaller portfolios will not show the same advantage for stock investments and may prefer index funds over mutual funds or stocks. But, as a portfolio gets larger, individual stocks gain a bigger edge over index funds on costs. Stock portfolios should thus do better than index funds if you can just let your System 2 do the thinking, and individual stocks give you other advantages such as better control over timing of realizing gains & losses, etc.


John Portwood from Louisiana posted about 1 year ago:

Kahneman has an important message in his book for investors. It is that simple screening methods or checklists often deliver results that are superior to unguided human judgement.


Charles Strout from New York posted about 1 year ago:

I am huge fan of Professor Kahneman and the work he has done over the last 30 years. He has incredible insights into psychology and how it impacts investor behavior. I only suggest that he may be a bit too overconfident in his conclusion that all individual investors should index. Rather, I think that individual investors should take his research seriously and develop systems to guard against the biases that he elucidates. It would seem that his research could lead to opportunities as well as pitfalls.


Scott Sneddon from California posted about 1 year ago:

The problem I have with this is the broad statement of the average investor will x, therefore all investors should do y.

There is a huge gap between the guy sitting next to me at work who has his money automatically going into some funds - he doesn't even know which funds - and someone who has taken the time to really understand the market and quite possibly might be very good at buying and selling stocks. The point of "average" is that it covers up the extremes, and you may very well have some great stock traders and others who aren't very good, and then you get your average.

So...who does this apply to? Who are these "average" people that the research was done on and what was their engagement level in investing and trading?

I really need the answer to that question to know if his research is useful.

The "average" person should not plan to be a pro football player, pro musician, or pro trader. But, there ARE pro football players, pro musicians, pro traders, and all the other "things that people can't do" but ARE actually able to do.

I'm not surprised by his conclusions at all, because most people I know just aren't that interested in following the markets closely enough to become good at picking stocks, but most people DO have retirement plans with stocks in them, so the result would seem to be really that most people aren't great at things they aren't very interested in (and don't know much about).

It would be interesting to see this research done on a subset of individual investors who "should" be able to pick good stocks and see if the thesis still plays out.

Out of my three portfolios, my highly-regarded index fund is by far the worst-performing and I will not be putting any more money into it. I'll add to the stock picks in my individual portfolio that are doing much better. Wait - I'm supposed to sell the ones that are doing good, right?;)

If this is true: "And we know that institutions do better than investors because they do not respond in the same way to news" then who is it that causes a stock to plummet 20% in minutes during after-hours trading? Individual investors are doing that? I doubt it.

There are some very good points made in the article, but I think they apply more to the general public than to the "individual investor," whatever that means. So be aware of these pitfalls, but don't waste your money on index funds...


Kermit Prather from Florida posted about 1 year ago:

Suggesting people buy an index fund instead of stock isn't the answer either. Yes, index funds are “safer” but like anything else when to buy and when to sell is very important. But you make it sounds like it’s a no brainer.

The answer is proper education in how to pick stocks, index or any other investment. The stock market is the only thing I know where people will put thousands of dollars at risk without doing a single thing of educating themselves.

As one who does investment education, I am constantly getting people who say I don’t want to spend all that time to learn how to do it. I just want to know where to put my money. I tell them in that case put it in your pillowcase, it’s a lot safer.


Donald W Giffin from Missouri posted about 1 year ago:

I subscribe to nine report letters with various perspectives and I religiously read them. I am a full time invester.

I own about 70 stocks which I select on the basis of inherent value. I f a stock comes to my attention that is better than one I own, and a short term loss is not in the picture, I switch. I sell when I don't understand why losses occur in a particular stock or when I do understand and think the market is not very smart. I focus only on my own portfolio and make all my own decisions.

The article seems geared to rookie investers. Neverthe- less, the warnings seem valuable.


David Vornholt from Hawaii posted about 1 year ago:

His comment about all of us not saving enough is well taken. But he does seem to be 'overconfident' in his own opinions and has a bias to the research he directs. This article also says that self education is futile. Anti AAII.


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