What was your portfolio return last calendar year? How did you perform relative to market indexes and other investors? Most investors don't know the answers to these questions. But their belief in their performance is quite flattering to themselves!
Two interesting studies illustrate this point. In the first study, William Goetzmann and Nadav Peles surveyed a group of investors belonging to the American Association of Individual Investors (AAII) and a group of architects about their retirement plan investment returns. The AAII investors are presumably very knowledgeable about investing from their participation in the association. When asked about their return the previous year, they overestimated their performance by 3.4% (= estimate - actual). Architects are very intelligent with a high degree of education, though they may not be knowledgeable investors. They overestimated their return by 8.6%. Both groups were also asked about their performance relative to a benchmark made up of the same asset allocation. The groups overestimated their relative performance by 5.1% and 4.2%, respectively. Investors seem to have overly optimistic perceptions of past performance. The authors attribute this to a psychological phenomenon called cognitive dissonance. The investors are mentally distressed by the conflict between a good self-image and empirical evidence of poor choices. To reduce the discomfort, investors adjust their memory about that evidence and those choices. This is then selectively re-enforced by noticing the returns of just their good performing stocks and mutual funds in the portfolio and not the poor ones.
Markus Glaser and Marin Weber also conclude that investors have biased views of their portfolio performance in the past. They surveyed individual investors from a German online brokerage firm and compared their self-assessments to their actual returns over four years. They reported a belief of an annual return mean of 14.9% over the period. Their actual return was more like 3.3%. Now that is overconfidence! In fact, there was no correlation between the actual return and the beliefs about the returns in the sample. What did these investors believe about their relative performance? They believed that 47% of the investors at the same brokerage earned a higher return then they did. Again, there was no correlation between the percentage of investors who actually did better and the self-reported belief. These authors point out that in order to learn from your choices, it is necessary to actually know what happened in the past. A biased view of the past impedes learning.
If you don't know that you are doing poorly as an investor, you won't learn from your mistakes. It is also more likely that you will stay with poorly performing stocks and mutual funds. So, know your return and compare it to major benchmarks to determine whether changes are needed in your strategy.
(References: Markus Glaser and Martin Weber, 2007, "Why inexperienced investors do not learn: They do not know their past portfolio performance," Finance Research Letters 4(4), 203-216, and William N. Goetzmann and Nadav Peles, 1997, "Cognitive dissonance and mutual fund investors," Journal of Financial Research 20(2), 145-158.)
