The March 15, 2006 edition of the Wall Street Journal featured an interesting article by Jonathon Clements entitled "Net Gains: How Watching Basketball Can Improve Your Approach to Investing" (subscription required). The article discusses various basketball analogies that highlight the common behavioral and cognitive mistakes made by investors. My favorite anecdote in the article deals with the eternal optimism of individual investors that they can overcome significant odds and consistently beat the market.
The following excerpt summarizes these common behavioral mistakes:
How often does a college basketball team that's trailing at halftime come back to win? Allan Roth, a financial planner with Wealth Logic in Colorado Springs, Colo., often puts this question to audiences. He says people typically guess that between 30% and 60% of teams make a comeback.
In fact, Mr. Roth looked at over 3,300 college games played in November, December and January and found that, among teams trailing at the half, less than 20% came back to win. Why do folks think the number is so much higher? Mr. Roth figures there are two reasons.
First, we tend to be overly optimistic. "It's America," Mr. Roth says. "We believe in the underdog -- and we believe in the small investor." Even though studies suggest that most investors lag far behind the market, we like to think we can beat the odds and come out on top -- which helps explain why market-tracking index funds still aren't that popular.
Second, comeback victories tend to get the most media attention, so they stick in our minds. "It's the same thing with hot mutual funds and hot money managers," Mr. Roth says. "Because investors only hear about the winners, they think it's easy to beat the market."
A recent article I read about institutional investment trends concluded that institutional investors have paid a huge price to buy Beta (or market returns) - paid in fees, risk and market impact. If institutional investors have paid a huge price for Beta then individual retail investors have paid ever more dearly for the privilege of underperforming the market through even higher active management fees and the costs associated with conflicts of interests in the sale of in-house mutual funds.
My advice is to enjoy March Madness and even root for the underdog if you like. But when it comes to investing please take what the market will give you by following a sound, risk-based asset allocation strategy and indexing through Exchange Traded Funds (ETFs). ETFs offer investors the efficiency and performance reliability of distributed institutional investment management at very competitive prices.
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