Economist, actor and author Ben Stein provides a blueprint for many of the mistakes investors make in his book, “How to Really Ruin Your Financial Life and Portfolio.” Rather than dissuading investors from making these mistakes, he “encourages” investors to trade frequently, believe that we can successfully pick stocks, put our money into hedge funds, etc. “In your heart, as you very well know, you are legions ahead of those average investors, and even legions ahead of the indexes,” he says.1 Mr. Stein’s “encouragement” not only playfully mocks the logic underlying many of these tactics, but also reveals insight into investor behavior that will help guide conversations between advisors and clients.
Nobel Laureate Daniel Kahneman refers to the belief that our own attributes are superior to those of others as “optimism bias.” Dr. Kahneman notes in an excerpt from his book, “Thinking Fast and Slow,”2 that optimism bias encourages people to pursue a course of action in spite of opposition or cost. The data bears this out, as we’ve seen in the SPIVA US Year End 2014 3 study that illustrates the impact that active manager optimism can have on investors’ portfolios.
Optimism bias also runs contrary to the idea of efficient markets. Mr. Stein includes two chapters dedicated to the question of whether individual investors can acquire information not already priced into securities: “Try Strategies That No One Else Has Ever Thought of… You Can Out-Think the Market” and “Believe that Those People You See on TV Can Actually Tell the Future.” These behaviors, which Mr. Stein pokes fun at, are driven by excessive optimism in the ability to incorporate information not currently reflected in securities prices. This excessive optimism can lead to risky and suboptimal portfolio choices that do not align with their own goals.
Many people are naturally optimistic, which is what makes overcoming the optimism bias so difficult. However, Mr. Stein poses this problem perfectly when he asks, “What is an index fund investor? A stock picker mugged by reality.”4
Understanding optimism bias, and helping clients overcome it, is necessary in order to avoid costly mistakes that can affect long-term goals.
