Last Updated Jan 7, 2010 12:33 PM EST
Here's an important question: How good an investor are you? Chances are, you think you of yourself as a money manager living in Garrison Keillor's Lake Woebegon, where everyone is above average. As a financial planner, I've noticed that many individual investors feel this way. So does nearly every money manager, financial planner, and other pro. This illusion of superiority is troubling, since most investors who consider themselves above average have portfolios that earn less than they think.
Driving Home the Point
When I give talks about investing, I often ask audience members to raise their hands if they think they’re below-average drivers. Typically, very few hands go up. In fact, studies show that 95 percent of us (including yours truly) view ourselves as above-average drivers. Dan Ariely, author of Predictably Irrational and a Duke University behavioral economics professor, says this is partly because we define “good driver” flexibly. One person might think of a good driver as someone who’s reasonably aggressive, while another might say it means having the fewest traffic tickets or accidents. Using different definitions to cherry-pick our standards is a bias Ariely calls being “simply human.” This bias also rears its head in investing, where we often cherry-pick our definition of market-beating performance.
What’s Beating the Market Anyway?
- It only includes the top 500 U.S. companies, leaving out returns of small- and mid-size companies that have historically outperformed large-cap companies.
- It excludes dividends paid by those top 500 companies, which account for about two percentage points of the S&P’s total return.
To support a claim of market-beating performance, you need to first define “the market.” The common definition is the Standard & Poor’s 500 index. But this yardstick has two biases that can make investors’ performances look better than they really are:
By using the S&P 500 as a market proxy, a widely perpetuated investing myth, the bar is set low enough for many investors who buy stocks and actively managed mutual funds to call themselves “above average.” Using the S&P 500 index stripped of dividends as a benchmark, however, crosses the line from being human to being evil, says Ariely.
The market-beating mayhem doesn’t stop there. People tend to switch their comparative yardsticks at will, making it easier to view themselves as above average. For example, in bad years for the stock market (such as 2008), an investor might make himself look good by benchmarking his balanced stock and bond portfolio against the lousy S&P 500, while in good years for stocks, he might choose a benchmark that’s part bond and part S&P 500. Terrance Odean, banking and finance professor at the University of California at Berkeley, says investors who do this are using mental accounting to frame their performance in a favorable light.
Pros Do It Too
It’s not only individual investors who claim above-average results. The agents they hire to help them invest — brokers, financial advisers, money managers, and consultants — frequently employ similar biases. Small investors hire these pros hoping that their expertise will deliver above-average performance, even after subtracting steep fees. That’s not how things work out, though.
As a reader of MoneyWatch, you probably know that actively managed mutual funds consistently underperform the indexes they aim to beat. Yet brokers and firms running managed accounts and hedge funds often claim to be above average by using the same mental accounting and S&P 500 tricks that individuals use. Even foundation consultants who hire money managers to invest for nonprofits have human and financial incentives to benchmark their advisers’ performances improperly in order to make themselves look good.
Avoiding This Costly Illusion
Ariely and Odean say the best way to avoid pretending you’re doing a better job than you really are is by defining your benchmark before investing. This way, you won’t let yourself hunt for ways to make your returns seem exceptional.
You also need to select a benchmark with the same risk level as your portfolio. A portfolio holding small- and mid-cap stocks shouldn’t be compared with the S&P 500. And you shouldn’t use Treasury bonds as a yardstick if your fixed-income holdings are all junk bonds.
I recommend benchmarking using Vanguard’s indexes (net of fees) of the broadest market measures: Vanguard Total Market Index (VTI; up 18.0 percent through October) for U.S. stocks, Vanguard FTSE All-World Ex US Index (VEU; up 29.4 percent) for international stocks, and Vanguard Total Bond Market Index (BND; up 3.8 percent) for bonds. Multiply your portfolio allocations by the appropriate index returns and then add the totals to get your portfolio’s true return.
Say you have a moderate portfolio that’s 40 percent in U.S. stocks, 20 percent in international stocks, and 40 percent in bonds. Your benchmark returns for the year through October are: 7.2 percent for U.S. stocks (.40 x 18.0), 5.9 percent for international stocks (.20 x 29.4), and 2.3 percent for bonds (.40 x 3.8), giving you a 14.6 percent return for your portfolio. Try using the simple worksheet below to see how your portfolio performed using the weighting of your portfolio. If you are lagging, the next question is, why not just own those three broad Vanguard index funds or something similar?
I’ve found that very few portfolios actually beat these simple benchmarks, adjusted for their allocations. That’s because we don’t really live in Lake Woebegon. So although shattering the “I’m an above-average investor” illusion can be painful, facing reality is worth it.
Illustrating the Above-Average Illusion
Here’s a hypothetical example of a money manager’s investment report. Notice how he framed his subpar returns to make himself look good.
Honest Al’s October 2009 YTD Investment Report: We are delighted to report that as of October 2009, YTD performance is a 19.0 percent return vs. the S&P 500’s 14.7 percent. Our 4.3 percentage point outperformance is due to our superior stock selection and our realization that markets would turn last March ...What really happened: The total return of the S&P 500, including dividends, was actually 17.1 percent. So by the true measure of the S&P, Honest Al’s 19 percent return beat the market by only 1.9 percentage points. But his portfolio also included small- and mid-size stocks as well as international stocks. So the true benchmark for his holdings actually delivered a 21.8 percent return. That means Honest Al lagged the real benchmark by 2.8 percentage points.
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