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Of course my returns beat the market!

Fellow passive-investing author Rick Ferri makes an interesting observation: Most investors don't know the rate of returns on their investments or how they did relative to appropriate benchmarks.

My experience jibes with Ferri's. Investors who know their rate of return, let alone those who are able to compare it to an appropriate risk-adjusted benchmark, are as rare as black swans. And while the list of mistakes investors make is almost endless, perhaps the worst of all is the failure to learn from experience. Even smart people make mistakes. But they learn from them and don't repeat the same mistakes.

Investors need to know what happened in the past without having a biased view. Unfortunately, the evidence suggests that investors generally don't learn from experience, so they keep making the same mistakes. One explanation for such irrationality is that people aren't aware that they're making mistakes. One 2007 study, "Why Inexperienced Investors Do Not Learn," found evidence supporting this explanation.

The authors, business professors Markus Glaser and Martin Weber of Germany's University of Mannheim, analyzed the performance of individual investors' online brokerage accounts. One objective was to determine whether investors were accurate in assessing their actual returns. The researchers compared investors' real results to how they thought they fared. Here, in brief, is what they found:

Bad guessing. Investors were unable to correctly estimate their own past portfolio performance.

Overrating. People overrated themselves. Only 30 percent of the participants in the study considered themselves to be merely average. Investors overestimated their own performance by an astounding 11.5 percent a year. And portfolio performance was negatively related with the absolute difference between return estimates and realized returns -- the lower the returns, the worse investors did in judging their realized returns. Investors seemed unable to admit how badly they had done. In fact, while only 5 percent believed they had negative returns, fully one-fourth fell into this category.

Underperformance. On average, investors underperformed relevant benchmarks. For example, while the arithmetic average monthly return of the benchmark was 2 percent, the mean gross monthly return of investors was just 0.5 percent. And more than 75 percent of investors underperformed.

To avoid these sorts of errors, ask yourself the following questions:

  • Do I know the rate of return on each of my investments and my portfolio as a whole?
  • Do I know how the returns compared to the returns of appropriate benchmarks?

If you're a typical investor, you're unlikely to have the correct answers. And that's not good because it's impossible to judge an investment strategy's success without knowing the answers to those critical questions.

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