I have a friend — we’ll call her Ai. She worked for a long time in the high tech sector, where she was exposed to a large number of tech companies and the people that ran them. Each new start-up Ai worked with was run by people who were smart, experienced, and convinced that they were sitting on a gold mine. Many of these tech gurus were highly successful investors who spent considerable portions of their strategy meetings bragging about their past successes. And so when opportunities arose to get in early and stake my claim to some of their projects, Ai leapt.
And Ai lost money big-time. Ai was not alone.
Yesterday, I described how the self-enhancement bias impacts what we know about the consumer experiences of our friends and acquaintances. I revealed that I once bought a Slap Chop that entirely failed to chop, yet I kept that to myself. I didn’t want anyone to know that I’d been such a fool. It’s likely that I wasn’t the first or last such fool among my circle of friends and acquaintances, but as of yet, it has never come up in conversation. More suckers throw down good money to get a chopper that doesn’t chop and which can’t withstand a decent slap.
But all that is probably no big deal in the long run. A few not-so-great purchases now and then isn’t normally disastrous. However, there is an arena in which the self-enhancement bias operates in a way that likely does cause people to make bad, even disastrous financial choices, and that is in the area of personal investing.
First, it is widely understood among researchers (but not among individual investors) that frequency of trading is directly linked to trading profitability: the more a person trades, the less money that person makes. Aside from catching the occasional wave when a company’s stock does incredibly well for a period of time, the best individual investment strategy is widely held by the experts to be that of buying shares in mutual funds that are indexed to the performance of the market as a whole, and simply holding them.
The historical performance of the stock market as a whole is one of relatively steady (at least in the big picture) increases. In their study of the Taiwanese stock market trades from 1995 to 1998, researchers Barber, Lee, Liu and Odean found that individual investors using an active trading strategy lost the equivalent of 2.2% of Taiwan’s gross domestic product and 2.8% of total personal income — more than was spent in Taiwan during that time on clothing and footwear. In contrast, the professional traders gained 1.5% from their trading during the same period.
So, what drives people to trade? Well, good news about our friends’ trades turns out to be a key driver. For example, members of trading clubs who regularly meet (either in person or virtually) to discuss their trading experiences, tend to trade more frequently and lose more money compared to the market and to people who are passive traders (those who buy a mutual fund and sit on it). Here, it seems that the relative ease of trading, plus the influence of friends who enthusiastically describe their successes tends to drive increased trading, which in turn results in lower returns. As with Ai, when people hear about the success of others, they erroneously believe they can experience the same.
Next, and very importantly, a very strong bias among individual investors is to believe that past performance is related to future performance. Despite the disclaimers in every stock prospective, we tend to believe that a stock can be hot. However, in general the fact that a stock or mutual fund has gone up two years in a row is unrelated to how it will do in year three. So, if you base your trades on the the successes your friends are claiming, you are probably jumping in too late anyway. If you have professional-level information about the stock or the fund, then you may be in the position to make a well-educated guess about its future performance. If your education in the matter consists of reading the Wall Street Journal every day and reading up on the company’s competition, you are probably are not qualified.
So, where does that leave us? The research suggests that you should probably take the stories your friends and acquaintances tell about their investing success with a grain of salt or two. They probably aren’t — ok, maybe they aren’t — lying about their success. But they are probably not telling you the whole story. And, it’s probably too late to get a piece of their successful action anyway.
To better understand the benefits of specific consumer choices, we continue to investigate the relationships between consumer preferences, psychological needs, happiness, and values at our website. At BeyondThePurchase.Org we help people make the connection between their spending habits – how do you spend your money and who do you spend it on – and their happiness. To learn about what might be influencing how you think about and spend your money, Login or Register with Beyond The Purchase, then take a few of our spending habits quizzes:
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In what ways do you hope your purchases will transform your life? The Transformation Expectations Questionnaire will tell you about what you expect from your next big purchase.
With these insights, you can better understand the ways in which your financial decisions affect your happiness.