I recently received an email question, printed below, asking why do smart people make bad investment decisions?
The question:
The question:
Mike,
I am wondering if you read the front page story in the Buffalo News (2/15/2014) about the investment broker 'bilking" people out of over 7.1 Million dollars. 5 were took for $5,600,000.
What really blew me away was the belief that a number of these investors were considered "sophisticated" investors.......
I read he was offering "quick turn - around" and profits anywhere from 4x to 15 x the original investment, w/o much risk
So...here is my basic question to you. How can someone who knows how to accumulate enough of the type money they gave this guy, also be foolish enough not to "smell trouble" when promised amazing returns, absent the type risk one would associate with those type returns ?
Returns like that do exist.....at the casino...the racetrack...high stakes private poker...
Do you actually find people that lost in your investment work ?
It amazes me....
From Ed out in Amherst NY
Response:
Great question Ed.
I think it comes down to a combination of three things:
1. People's lack an of understanding of capital markets: how they work, their history, characteristics, and risks. In addition they don't know the first thing about the tenets of Modern Portfolio Theory, Efficient Market Theory and Behavioral Finance. There are libraries of materials, studies, and research devoted to these topics.
Yet:
2. We have a culture: movies, books, TV shows, that ignore the evidence, and science, and propagate the idea that if you are sharp enough, or hire the right person, you can beat the market or gain large returns with little risk. That is not even close to the findings of academic research and /or financial history. People have no idea that the theories and rules mentioned in item 1 above exist. All they see are the few stories (fiction and non-fiction) of those who made easy money in the market by picking the right stock or investment.
Then there is:
3. Greed: We know from MRI studies of the human brain, that the brain on cocaine looks just like the brain of a gambler. Emotion trumps rationality. The smart person falls for the promises of the silver tongued salesman.
So, simply, many people (many of them very smart) believe that excess returns can be gained in the market by outsmarting the market. Very few learn, or can conceptualize, that beating the market is a near impossible task.
They are hard wired to chase possibilities (emotional brain) not probabilities (rational brain).
They forget this maxim from the great economist, John Maynard Keynes:
"Its better to be approximately right than precisely wrong"
An earlier blog post of mine emphasizes the point on how hard it is to beat the market:
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Next time you think you, your mutual fund, your broker, your stock picking software can beat the market; scan the graphic below and read this short excerpt from Business Week July 16-21, 2013, "The Hedge Fund Myth"
"Hedge funds are built on the idea that a smarter guy (and they are almost all guys; only 16.8 percent of managers are women) with a better computer can make miracles possible by uncovering inefficiencies in the market or predicting the future. In pure dollar terms, there are more resources, advanced degrees, and computing firepower devoted to chasing this elusive goal than almost any other endeavor, and that may include fighting wars. Yet traders face the immutable fact that every second, each megabyte of information, blog post, one-line rumor, revenue estimate, or new product order from China has already been taken into account by the efficient market and reflected in a security’s price. This means that trying to gain what traders call an “edge,” at least legitimately, is almost impossible. As the financial incentives on Wall Street have become enormous, so have the competition and pressure to gain an advantage at any cost."
Full Article: http://www.
Posted by AWM BLOG
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