Be a Better-Than-Average Investor

Last Updated Dec 13, 2010 2:56 PM EST

If someone described you as "average" at investing, would it make your blood boil? It shouldn't, because being "average" (or even below average, in some cases) when it comes to investing could actually make you better than most other investors.

In his book, What Investors Really Want, Meir Statman shows how the desire to be above average leads investors to trade too much, and how costly a mistake that can be. The trading records of thousands of investors at a American brokerage firm showed that the returns of the heaviest traders trailed those of index investors by more than 7 percent a year, while the lightest traders trailed by only 0.25 percent per year. That means that the heavy traders were taking the risks of stocks while earning Treasury bill-like returns.

But, this isn't solely an American phenomenon. The trading records of thousands of investors at a Swedish broker revealed that on average the losses of heavy traders amounted to 4 percent of their net worth each year.

Statman noted that "beat-the-market" investors trail the market and passive/index investors because they tend to buy high and sell low. For example:
  • Investors who switched mutual funds frequently trailed buy-and-hold mutual fund investors by about 1 percent if they switched between large-value funds, 3 percent if they switched among small growth funds and 13 percent if they switched between technology funds.
  • Hedge fund investors did no better than mutual fund investors regarding switching, underperforming buy-and-hold hedge fund investors by about 4 percent a year. And those who switched among the funds with the highest returns trailed by about 9 percent per year.
These statistics support what academic research has demonstrated: There's no persistence in outperformance beyond the randomly expected among either mutual funds or hedge funds. And while the average mutual fund underperforms its risk-adjusted benchmark by about 1.5 percent a year (pretax), the average hedge fund has provided risk-adjusted returns that have had a hard time keeping up with Treasury bills!

Overconfidence is such a huge problem that it even causes people to delude themselves -- the truth is so painful that the delusion allows us to continue to be overconfident. Members of the American Association of Individual Investors overestimated their own investment returns by an average of 3.4 percent, and they overestimated their returns relative to the average investor by 5.1 percent.

Statman also noted that this overconfidence leads to unrealistic optimism, causing investors to concentrate their portfolios in a handful of stocks rather than gain the benefits of diversification (the only free lunch in investing).

While confidence is generally a good trait to possess, helping us feel good about ourselves, confidence in our ability to beat the market has proven detrimental to investor's financial health.

More on MoneyWatch:
Investors Trade Returns for Prestige Our Own Worst Investing Enemy: Why Overconfidence Is a Problem Are You Delusional About Your Investments? The End of Social Security's Interest-Free Loan Active Managers Take a Beating in 2010
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    Larry Swedroe is director of research for The BAM Alliance. He has authored or co-authored 13 books, including his most recent, Think, Act, and Invest Like Warren Buffett. His opinions and comments expressed on this site are his own and may not accurately reflect those of the firm.

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