As an investor, it can be tempting to try to “beat the market.” In fact, many “active” investors assume they can do just that, even when evidence shows that market timing does not add value, on average.
So, why are so many people choosing active fund managers or, as amateurs, to actively manage their own funds? Here are some of the main reasons and mistakes that lead people to assume that their active management will be successful.
Assuming that Practice Makes Perfect
In most disciplines, your improvement is based on how much you practice. A surgeon who has worked in the field for many years will generally operate with more precision and confidence. An athlete who has practiced shooting free-throws over and over is not likely to miss. However, investing is not like other disciplines. Unlike these other professions, investors are in a market that is efficient and unpredictable. Outperformance in the past has very little predictive power concerning whether your strategy will outperform in the future.
Nevertheless, many amateur investors assume that past performance is predictive of future results. It is easy to find strategies that have outperformed recently, but zoom out and you’ll find that on average, even the most experienced and intelligent investors underperform their benchmarks.
The bottom line is, no amount of experience creates a better-than-even chance of outperformance.
Overconfidence and Confirmation Bias
“Confirmation bias” is the tendency to only take note of things that confirm existing beliefs, while subconsciously discarding any other evidence. Confirmation bias happens all the time in daily life, and can be especially prevalent in investing.
When actively investing, it is easy to take note of your wins. You celebrate and focus on them; they add to your ego as an investor. You begin to believe that you are an above-average investor and that you will continue to perform well. On the other hand, when you lose money, you blame the market or some other outside source. That evidence is discarded, and you do not use it to reflect on your personal investing skills. Not seeing your weaknesses clearly can lead to overconfidence and detrimental investing mistakes.
Planning to Beat the Market
One of the biggest mistakes active investors make is assuming they can beat the market. While some active medical financial advisers may do this in the short term, they rarely bring enough value to outweigh their fees over long periods of time.
Individual investors who actively buy and sell funds may also feel confident that their own expertise will allow them to beat the market. However, no evidence suggests that active funds beat the market on any consistent basis. In fact, in the last ten years, passive index funds outperformed actively managed funds 77% of the time*.
Measuring Against… What?
Finally, what are you using as your measuring stick?
Many active DIY investors measure their returns against zero, rather than comparing them to an appropriate benchmark. You may get positive returns that appear impressive, but as a rising tide lifts all boats, it’s easier to get positive returns in rising markets. Comparing your returns against an appropriate benchmark is the only way to reliably evaluate your results. Even if you feel you are doing well as an investor, it is crucial to benchmark against something that will accurately demonstrate your success.
At IMA Financial Services, we understand that timing markets is unlikely to lead to outperformance. We create academically sound, highly diversified and low-cost portfolios for our clients so you can be confident that your money is efficiently working for you. Contact the Boise financial planning firm for physicians that you can trust today!