Why Do We Assume We Are Smarter Than The Other Guy?

Humans (and probably more men than women in this case) are a very weird and irrational species at times. When I watch TV or surf the net and see the incredible amount of money that is spent trying to attract small-scale individual investors to various financial products I tell myself that there must be a ton of people out there trying to pick stocks on the stock market, or even “day trade” where people take positions on stocks and get out just as quickly while trying to make a quick buck. Everyone out there appears to have the answer or the system for you. It is actually amazing to me how well this must work, because these companies have millions of dollars in advertising budgets, so they must have done a cost-benefit analysis and found out that they could make a lot of money off of stock pickers. That often leads me to wonder how we can be so arrogant as to think that we stand a good chance of beating the market over an extended time frame. “The market” is the average rise and/or fall of the market you are trading within and there is a reason why it is the numerical average!

The Exceptions That Prove The Rule

Now I’m not talking about every individual investor out there. I know some people (mostly blog owners) who know one fairly specific part of the market very well, who never panic, and always stick to their investment plan. They might beat the market some of time, and a few may even beat it over a long term. The vast majority of individual investors severely underperform the market however. A recent Dalbar study revealed that during a recent 20 year stretch the S&P 500 returned an average of 9.1% (a little off of its historical average of 10.4%, but still not too bad), yet the average investor only realized gains of 3.8%! Think about just how bad so many investors would have to be for that to be the average over a fairly significant term where the stock market did just fine.

Who Said The Playing Field Is Even?

What so many people seem to forget is that anytime you make a trade on the stock market there is someone else at the other end of that trade and they think they got the better end of the deal as well! Now in my ETF book I pointed out that it probably isn’t an even playing field between you and whoever else is at the other end of that trade. If the stock market were solely the domain of individuals purchasing shares and trying to outduel each other by reading financial statements, I think that a lot of people (about half actually ;) ) would likely beat the market. This is definitely not the case however. In today’s investment world chances are great that your trading against a supercomputer that has been set up with a high-frequency trading algorithm and executes thousands of trades every minute in order to take advantage of split second shifts in market momentum. If you’re not trading against them you are likely up against a hedge fund manager who has political insider information, is working with others to shift a market, or has many other institutional advantages. Take the new Facebook IPO as a great example of insiders benefitting from information the general public didn’t have, and then working to drive the price of the stock down as they “shorted” it and made money as the stock went in a negative directions.

Now when you are up against those sort of odds, and when you have some pretty heavy fees and commissions chipping away at your trading profits, your odds just aren’t very good that you will beat the market no matter how good your instincts and system are. I believe that by some skill and a lot of luck, there are a few individuals that beat the market for short-to-moderate periods of time, and then make a lot of money by touting their success as an “expert” in the market. The thing is that study after study shows investors being pulled back to the average the longer they keep up their trading ways. The vast majority of professional money managers that head up mutual funds can’t even beat the market, and that is a sobering fact for a small-scale trader in my opinion.

“If Everyone Is Special, Then No One Is”

So what makes us think we are superman? Is it just that infamous male ego (and sometimes female ego) that lead us to believe we are the smartest person in the room (“the room” in the stock world is literally anyone with capital and an internet connection)? Is it the fact that we have experienced success in other areas of life when we applied ourselves, so we believe the same logic will hold true when we compete in the jungle that is the stock market? I’m not sure, but basic logic tells me that I don’t want to compete against the sharks that swim in the stock market on a daily basis. I often listen in Jim Cramer’s show Mad Money when I’m in my car just for the entertainment value. While I think Cramer actually does know what he is talking about a fair degree of the time, I am shocked by the lack of financial fundamentals many of his callers have regardless of how much they are actually investing. Whatever it is that makes them think they can work a full-time job, out-think NASA-level computer engineers and Ivy League hedge fund managers, and take positions more efficiently than Warren Buffet, I want to stay as far away from that as possible.

I’ll stick to my passive investing, and let people that are smarter than I duke it out and set the market! My dad used to tell me that the only thing worse than someone that was dumb, is someone that was dumb to know how dumb they actually were. I guess that was his way of interpreting Socrates’ “The only true wisdom is in knowing you know nothing.” Regardless, I think many of us would do well to remember this the next time we go to jump on “the next great stock tip” we heard at the water cooler.