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To Win at Investing, View the Market Correctly

Many of the errors we make as investors are a result of how we frame problems. By looking at the market correctly, we can avoid many of these errors.

The framing problem goes beyond just our investments. Consider the following examples from Jason Zweig's excellent book Your Money & Your Brain.

  • One group of people was told that ground beef was "75 percent lean." Another was told it was "25 percent fat." The group that heard about fat estimated that the meat would be 31 percent lower in quality and taste 22 percent worse than the lean group predicted.
  • Pregnant woman are more willing to agree to amniocentesis if told they face a 20 percent chance of having a child with Down's syndrome than if told there is an 80 percent chance they will have a baby without it.
Statman uses the analogy of playing tennis against a practice wall to show how individuals frame the "game" of investing in the wrong way, leading to costly errors. Playing tennis against a wall, where you can more easily return shots, is very different from the game of investing, where you're playing against professionals who are much better players and won't tell you where they are going to hit the ball.

However, Statman goes on to note that: "It is natural for us to adopt the frame of the beat-the-market game as tennis played against a practice wall because that frame is generally correct in our daily work. We gain competence at our work as surgeons, lawyers or teachers by study and practice, as we gain competence playing tennis against a practice wall. In time, with practice, we get it right."

Statman goes on to note that: "We cannot be competent surgeons with little knowledge of the human body." However, investing is entirely different. We can be competent investors with virtually no knowledge of the companies in which we invest. While surgeons or lawyers with little knowledge in their fields can't hope to earn average salaries, investors with no knowledge of the stocks they're buying can earn market returns by simply investing in index funds. And since the average actively managed fund underperforms its benchmark index fund and the average active investor underperforms the very funds in which they invest, the know-nothing index investor earns above average returns by simply earning market returns.

Legendary investor Peter Lynch put it this way: "[Investors] think of the so-called professionals as having all the advantages. That is total crap. They'd be better off in an index fund." Warren Buffett agreed: "By periodically investing in an index fund the know-nothing investor can actually outperform most investment professionals."

There's an old saying that if you can't spot the sucker at the poker table, then you're the sucker. The analogy for investors trying to beat the market by trading is that there must be a seller for every buyer and only one of them can be right. And since the vast majority of trading is done by institutional investors, the other side of the trade you make is likely to be a big hedge fund, mutual fund or other institutional investor, not another individual. Once you learn frame the problem of trying to beat the market this way, it's easy to see who the sucker is likely to be and why individuals who trade are highly likely to underperform.

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Hear Larry Swedroe discuss current investment trends and topics every Sunday at noon on 550 AM KTRS in St. Louis or streaming via the KTRS Web site. Can't catch the show? Download the podcast via www.investmentadvisornow.com or through the Buckingham Asset Management podcast page on iTunes.