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Why Investors Are Not Dumb!

  • Written by Syndicated Publisher No Comments Comments
    November 2, 2012

    How often do we hear statements like “Most of the ‘smart money’ is going into energy stocks right now”? Or advice to “Watch what the ‘smart money’ is doing”.

    I use the term myself in reference to what usually savvy corporate insiders, institutional investors, hedge-funds, and other professional investors are doing at the time, in comparison to high or low levels of bullish investor sentiment.

    Unfortunately, the term ‘smart money’ has led to increasing use of the term ‘dumb money’ in some market writing, the implication that non-professional investors must be dumb if only professionals are included in the term ‘smart money’.

    That is totally unfair and inaccurate. Individual investors are most definitely not dumb or stupid. That would be virtually impossible just given the fact that they are able to be investors.

    Individual investors would have to be among the most intelligent, knowledgeable, successful people on the planet to have the success in their chosen careers that provides them with assets over and above that needed to provide well for themselves and their families, assets that can be invested.

    You don’t get to be a successful artist, attorney, doctor, engineer, scientist, business executive, salesman, small business owner, or whatever, by being anything but knowledgeable, intelligent and even brilliant. Can’t be done.

    Yet it is true that the so-called ‘smart money’ buys low, sells high, and thrives from their investing, while the majority of individual investors, while often successful for fairly long periods, either lose money over the long-term or fail to match the gain they would make by simply leaving their money in the bank.

    That’s clear from numerous studies on the subject.

    Research firm Dalbar Inc., published a study in 2003 titled ‘Quantitative Analysis of Investor Behavior’. It showed that from 1984 – 2002 the average annual return of equity mutual funds was 9.3%, while the average annual return of investors who invested in those funds was only 2.6% over the same period.

    A similar Dalbar Inc. study of bond investors in 2006 showed that over the 20-year period from 1986 – 2005, the Long-Term Government Bond Index had an average annual return of 9.7%. But the average annual return of bond investors was just 1.8%.

    So what could be the problem for obviously intelligent and smart individual investors?

    According to other studies, the very fact that they are smart, knowledgeable, intelligent and successful – in whatever is their own field of expertise – may be the problem, as it may cultivate over-confidence when they step into money-management, a field that is not their area of expertise.

    For instance, a survey by the Securities Investor Protection Corporation (SIPC) in 2001 revealed that 85% of U.S. individual investors (which we’ve already acknowledged are in the upper percentile of the population for brilliance and success in their lives and careers) were unable to pass a simple five question investment ‘survival’ quiz.

    In 2009, the Investor Education Foundation of the Financial Industry Regulatory Authority (FINRA) conducted a similar investor survey.

    Interestingly, 67% of respondents rated their own financial knowledge not as average but as high. Yet by far the majority failed FINRA’s test of their knowledge of even the most basic of financial questions.

    In 2012, the Securities & Exchange Commission published a report on financial literacy among non-professional investors. Its conclusion was that “U.S. investors lack basic financial literacy, and have a weak grasp of even elementary financial concepts.” Of even elementary financial concepts! Yet the majority rate their financial knowledge as high.

    It’s obviously a potential obstruction to investing success when those suffering the consequences don’t even realize they have a problem, and so keep investing the same way in every cycle, making the same mistakes over and over, while expecting the results to be different.

    The FINRA Foundation notes that if the majority of investors lack even elementary investing concepts, yet rate their knowledge and competency as high, it makes it difficult to change the pattern of under-performance.

    Gerri Walsh, president of the FINRA Foundation says, “There are a lot of people who think they’re good at handling their money, but their results tell you otherwise. Those people are going to be particularly difficult to reach and educate because they don’t think they have a problem.”

    The conclusions many investors draw from their investment experiences also do not change. The market is a great teacher, but its lessons are often not learned.

    Profits in rallies and bull markets are due to their own talent and ‘feel for the market’. However, losses from corrections and bear markets are not their fault, have nothing to do with their degree of investing knowledge, experience, strategy, or ‘feel for the market’. It was just bad luck, or more often the fault of the crooked market, or their broker, or the stupid government.

    SIPC Vice-President Robert O’Hara said, “We’ve been at this for more than 50 years, and we see the same problem over and over again. Investors are enticed in during bull markets, but then don’t know what to do when things turn sour later. People need to take the time to learn the basics about investing, and how to put them into practice.”

    It seems like a reasonable suggestion given the statistics.

    Sy Harding is president of Asset Management Research Corp, and editor of www.StreetSmartReport.com, and the free market blog, www.streetsmartpost.com. He can also be followed on Twitter @streetsmartpost

    Images: Flickr (licence attribution)

    About The Author

    Sy Harding publishes the financial website www.StreetSmartReport.com and a free daily Internet blog at www.SyHardingblog.com. In 1999 he authored Riding The Bear – How To Prosper In the Coming Bear Market. His latest book is Beat the Market the Easy Way! – Proven Seasonal Strategies Double Market’s Performance!