How your mind fools you into believing you can beat the market – The Wall Street Journal

___STEADY_PAYWALL___.Many amateur investors believe they can do a better job of managing their own money than professional fund managers. But, the evidence suggests that they are fooling themselves. How is it that so many smart people over-estimate their investment expertise? Behavioural finance expert Meir Statman has a fascinating way to explain how we mistakenly allocate investment to tasks that are easy to perform. Our brains are wired into making short-cuts in decision-making and we allocate investing to the wrong box. His theory resonates with other ideas about behavioural finance, not least of all from Daniel Kahneman, the Nobel prize-winning psychologist who drew on cognitive pyschology to develop important insights on how people make economic decisions. Kahneman is the author of Thinking, Fast and Slow, which looks at important issues like loss aversion and over-confidence among investors. – Jackie Cameron The mental mistakes that active investors make. By Meir Statman(The Wall Street Journal) – In the battle between passive and active investing, there's no question: Passive has been the clear winner. For years, the flow of new assets has gone more to low-cost, widely diversified index mutual funds and exchange-traded funds, rather than to actively managed funds.It makes sense. There is much evidence that passive investors, who are content to match the market, earn higher returns than active amateur investors, who strive to beat the market.That's true even for investors who delegate their investments to managers of active mutual funds. Managers of active mutual funds do beat the market on average, but the fees they charge equal or exceed the extra returns they generate.Read also: WORLDVIEW: Is it passive investing that's lying – or active?Yet many amateur investors remain active investors, either by investing on their own, by buying actively managed funds, or by actively buying and selling funds in an effort to beat the market. Why is that, when the evidence is so clear that it's more than likely to be a fool's errand?The answers can be found in our minds. We all use mental shortcuts that help us make the best choices. But those shortcuts turn into mental errors when they take us far from our best choices. Mental errors can induce amateur investors to choose active investing.It's all how we frame itFraming a problem in the right way can help us find the right solutions to complex problems. But too often, investors misframe problems—leading them to find the wrong solutions to simplified problems.Amateur investors regularly think of stock trading as similar to such skills as surgery, driving, cabinetmaking or plumbing. All these professionals get better at their work as they do more of it. Framed this way, investors assume they can improve their performance as they trade more often. The more actively they trade, the more money they will make.Read also: WORLDVIEW: Active versus passive debate misses a key pointBut investors are framing this all wrong. Pipes and fittings do not compete against plumbers, inducing them to choose the wrong fitting. By contrast, traders always face competing traders on the other side of a trade, sometimes inducing them to choose the wrong trading strategy.Active investors often commit another framing error: comparing their returns relative to zero, rather than relative to the market return they would get with an index fund. A 15% annual return delivered to active investors sounds excellent, but it is inferior when a low-cost, widely diversified index fund delivers 20% to passive investors.The curse of overconfidenceAsk yourself these two questions:Are you an above-average driver?Are you an above-average juggler of three oranges?More than half of the people who were asked these questions placed themselves above average in driving but below average in juggling. People tend to place themselves above average when tasks are easy, such as driving; after all, we drove today from home to work and back with no accident. We neglect to note that, on average, people drive from home to work and back with no accidents.Conversely, people tend to place themselves below average when tasks are difficult, such as juggling; we remember how the three oranges soon plopped to the floor. We neglect to note that, on average, oranges juggled by other people also soon plop to the floor.For many investors, trading stocks seems more like driving than juggling. That's especially true if they've already succumbed to the framing errors mentioned above—they've practiced, so they think they're getting better. Such investors are like tennis players who have played against a practice wall and think they're pretty good. However, if they measured their abilities against possibly better opponents on the other side of the net, their confidence levels would be more aligned with their abilities.Foresight vs. hindsightActive investors often confuse foresight and hindsight. They believe that if they have been fortunate (read: lucky) enough to have predicted previous ups and downs, they will do so again. In his biography of Warren Buffett, writer Roger Lowenstein described Mr. Buffett's reaction to the increase in the Dow Jones Industrial Average beyond 1000 in intraday trading in early 1966 and its subsequent decline by spring. Some of Mr. Buffett's partners warned him that the market might decline further. Such warnings, said Mr. Buffett, raised two questions:"1. If they knew in February that the Dow was going to 865 in May, why didn't they let me in on it then; and"2. If they didn't know what was going to happen during the ensuing three months back in February, how do they know in May?"Warren Buffett clearly is proficient at distinguishing between hindsight and foresight.In search of evidenceOne of active investors' biggest mistakes is searching for evidence that will confirm their beliefs, while neglecting or assigning less weight to evidence that disputes what they think.Active investors therefore count gains that confirm their image as winners while they overlook losses that undermine that image. They also often avoid the hard calculations that might disprove their investment prowess. Indeed, a study of members of the American Association of Individual Investors found that they overestimated their own investment returns by an average of 3.4 percentage points a year relative to their actual returns, and they overestimated their own returns relative to those of the average investor by 5.1 percentage points.Compared to what?We all use certain anchors, or benchmarks, so we can use the right numbers to measure things against. When selling a house, for instance, we begin by finding the average price of houses sold recently in the neighbourhood.But that can lead us astray when we begin with a faulty benchmark, such as the average price in a more prestigious neighbourhood.Many active investors fall into that faulty-anchor trap. They do that by assuming that stock prices are anchored in a channel defined by past prices. Because of this assumption, many investors look to buy shares when their prices are close to the bottom of the channel and selling them when their prices are close to the top of the channel. The premise of this strategy is faulty, however, because stock prices aren't anchored in any channel.One popular channel is the one defined by the lowest price during the past 52 weeks as the bottom anchor, and the highest prices during the past 52 weeks as the top anchor. The 52-week channel strategy is especially popular among amateur investors because the 52-week high and low prices are readily available in stock reports. Yet the strategy fails to beat the market. Indeed, professional investors tend to buy stocks sold by amateur investors when prices are close to the 52-week high price, generally gaining at the expense of amateur investors.Flip of a coinWe use representativeness shortcuts when we assess the likelihood of events by their similarity to other events. So, for example, if we eat at a restaurant six times and the food is good every time, we can be pretty sure that the food will be good the next time we eat there.Investors think about stock picking along the same lines. They believe that six years of beating the market, or even less, is representative of a skilful mutual-fund manager. But variation in the quality of meals at a restaurant tends to be small, whereas variation in the performance of a mutual fund tends to be large. We can predict quite accurately the quality of future meals at a restaurant by the quality of six past meals, but we cannot predict nearly as accurately the future performance of a mutual fund by performance in six past years. That's why the active investors' tendency to "chase returns," switching to mutual funds with recent high returns, tends to lower amateur investors' returns more often than it increases them.In addition, just looking at how one particular fund did against its benchmark over six years ignores the information about the returns of all funds relative to their benchmarks.Yes, beating the market six years in a row seems like an admirable feat. After all, the odds of getting six heads in six flips of a coin is only one in 64. So, we assume, there has to be more than luck involved.But once we note that few mutual-fund managers beat their benchmarks consistently over years and know that this fund manager is one among hundreds or thousands of fund managers in the population of funds, we understand that it is as likely that there would be lucky fund managers who beat their benchmarks six times in a row as there are lucky coin flippers who flip six heads in a row.We don't know what we don't knowWe assess the probability of events by information that is readily available in our minds. That becomes a problem when there's an enormous amount of information that isn't available – and we aren't aware of its absence.That happens all the time with investments. Amateur active investors are frequently buyers of attention-grabbing stocks and funds, such as those in the news, those with extreme trading volume, and those with extreme one-day returns. That is understandable: It isn't easy to search among the thousands of stocks that investors can buy.Yet that only amplifies the tendency of investors to flock to recently featured mutual funds or stocks with high returns—and ignore funds and stocks that get little mention. But as previously noted, the chance that any one person will invest in a fund manager who consistently outperforms the market, or pick one high-returning stock out of the myriads that fail to do well, is awfully small.The thrill of the chaseOf course, people don't pursue active investing just out of mental errors. It's also about desire. Some of that desire is the yearning for extraordinary gains, which is unlikely to be satisfied if you're content with matching the market. But some of it is about more intangible desires.To understand this better, consider crossword puzzles. Isn't it silly to waste time solving a Sunday crossword puzzle? After all, you can find the solution to the puzzle in the same newspaper next Sunday. And isn't it silly to waste time and money in solving stock puzzles when evidence indicates that active trading based on amateur stock solutions is more likely to bring losses than gains?The obvious answer is that some people derive other kinds of benefits from playing games and solving puzzles.This is evident among Dutch investors who agreed with the statement, "I invest because I like to analyse problems, look for new constructions, and learn," and the statement, "I invest because it is a nice free-time activity," more than they agreed with the statement, "I invest because I want to safeguard my retirement." This also is evident among the quarter of American investors who said that they buy stocks as a hobby or because it is something they like to do.A Fidelity survey of amateur traders revealed that 54% enjoy "the thrill of the hunt," 53% enjoy learning new investment skills, and more than half enjoy sharing trading news with family and friends. In short, they invest not just for profit, but also for the fun of playing and the hope of winning.In other words, active investors make a lot of errors with their money because of the way their minds work. But sometimes, it isn't necessarily a mistake, because it isn't necessarily about the money.Dr. Statman is a finance professor at Santa Clara University's business school and author of "Behavioural Finance: The Second Generation" (available free at cfainstitute.org). He can be reached at reports@wsj.com.