FREE NEWSLETTER

Why We Go Wrong

John Lim

I’VE LONG BEEN flummoxed by the difficulty people have managing money. It all seems so intuitive: Save, invest, repeat. Buy more when the market falls and a lot more when it crashes. Rebalance by adding more to losing asset classes—which today means buying value and international stocks.

Now, don’t get me wrong: I’m no financial genius. I’ve made my share of blunders. But I also know that being a do-it-yourself investor has saved me boatloads of money. When I’ve encouraged colleagues to do the same—imploring them that “it’s really not that hard”—I’ve received only steely stares and blank looks.

It’s slowly dawned on me that the financial demons people wrestle with are real and of Herculean proportions. Finance is a minefield that few navigate without getting maimed. It’s replete with mirages—what you see is often not what you get. Our instincts hurt us more often than they protect us. Actions that are sensible in every other realm of life lead us astray in finance.

What follows is an exploration of eight key concepts that many—and perhaps most—investors struggle with. The biggest paradox of all: While managing money may appear simple, it’s anything but.

1. Compound interest is the key to wealth. We’re woefully ill-equipped to wrap our heads around the wonder that is compound interest. Warren Buffett described his eureka moment at age 10. “That’s where the money is,” he told himself, referring to the power of compound interest.

The miracle of compound interest is a collision of two intangible concepts—exponential growth and a long time horizon. It’s well known that people struggle when making decisions that have consequences well into the future. Economists refer to such myopia as “present bias,” a universal human tendency to favor the present over the future.

The abysmally low U.S. savings rate exemplifies this mindset. But it also reflects a failure to grasp the immense power of exponential growth over long stretches of time. In brief, we each need our own eureka moment.

Consider the story of the Lenape Indians. In 1626, they sold the island of Manhattan to Peter Minuit for a mere $24. That was the greatest swindle in U.S. history, right? If you compound $24 at 7% a year—which is the average after-inflation return of the stock market—what would it be worth today? Almost $10 trillion. Let that sink in.

2. Laziness is a virtue. Life teaches, and common sense affirms, that hard work pays off. Sloth was so disdained in medieval times that it was labeled one of the seven deadly sins. Yet lazy investing leads to superior, not inferior, results.

Nearly every action an investor takes turns out to be counterproductive. For example, investors tend to sell their winners and hold on to their losers, exactly the opposite of what the tax code rewards. More important, such behavior leads to inferior results, because it flies in the face of momentum, the tendency for rising stocks to continue rising.

Overconfident in their predictive prowess or perhaps simply out of fear, investors also attempt to time the markets, jumping in and out of stocks like grasshoppers. Not only is this an exercise in futility, but also it leads to lower returns. Time in the market—the secret sauce of compound growth—is the key to long-term investing success, not timing the market.

3. Sales on Wall Street shouldn’t be shunned. When cashmere sweaters are marked down 70%, customers buy in droves. But when the stock market goes on sale, investors shun its merchandise. It’s easy to ridicule such behavior as irrational. But when you dig deeper, you discover there are sensible reasons behind our reluctance to buy.

For one thing, sales on Wall Street are usually accompanied by bad news and grave uncertainties. The deeper the sale, the bleaker the news. When stocks sold off in February and March 2020, we were in the midst of a global pandemic and total lockdown of the economy. Plunging share prices felt less like a sale and more like a markdown of damaged goods.

Another key difference between Main Street and Wall Street: When a sale occurs on Wall Street, investors may be potential buyers of shares, but often they’re already significant holders. As owners of stocks, the marked down merchandise is rightly viewed as a loss and those losses hurt. The financial pain we experience makes us wary and more cautious. In financial parlance, we grow risk averse and that risk aversion makes buying more stocks—even at fire-sale prices—exceedingly difficult.

That brings us to another great paradox: Just when stocks are deeply discounted, and thus the risk of owning them is lowest and prospective returns are highest, our risk aversion peaks, making it nearly impossible to muster the courage to step up and buy.

4. Following the herd can be dangerous. As a species, we find comfort in crowds. Walking alone down a dark city street puts us on edge. But walk down the same street in the middle of a bustling crowd and we’ll feel at ease. This herding instinct has served us well as a species and helps us cope in nearly every domain of our life—but not investing.

Herdlike behavior leads to financial excesses—financial bubbles at one extreme and market collapses at the other. Following the crowd during such times feels safe, but ultimately it can lead to great wealth destruction. Think back to the dot-com bubble of the late 1990s or, for a previous generation, the Nifty Fifty stocks of the late 1960s and early 1970s. Both ended badly.

Our Weekly Newsletter

Resisting the herd during a mania sounds easy in theory, but it’s rarely so in practice. Even the great physicist Isaac Newton succumbed to the South Sea Company stock bubble of 1720, losing £20,000 in the process, the equivalent of some $3 million today. As he put it, “I can calculate the motions of the heavenly bodies, but not the madness of people.”

5. Main Street and Wall Street are worlds apart. The stark contrast between the economy and the financial markets—Main Street and Wall Street, if you will—is one of the great paradoxes in finance. We are witnessing this today. The gulf between the economy and the stock market has perhaps never been wider.

The most counterintuitive and yet historically reliable pattern is that financial markets begin to rebound when the economy is still hitting rock bottom. Conversely, it’s just when employment is peaking that recessions—and accompanying bear markets—are just around the corner. This bizarre relationship stems from two related quirks of financial markets.

First, markets look ahead. How the stock market behaves today is a reflection of what investors see six to 12 months down the line. Second, inflection points in the economy—when things go from terrible to just bad or from great to merely good—matter far more to markets than the absolute state of the economy. In other words, a terrible economy that’s getting less terrible leads to rising stock markets, while a great economy that starts growing more slowly may trigger falling share prices.

6. A great company can be a bad stock. Financial history is replete with examples of this paradox. The Nifty Fifty stocks were the blue-chip companies of their day—stocks like IBM, General Electric, Coca-Cola and Xerox. These were wonderful growth companies but ended up being terrible investments. Ditto for the internet companies of the late 1990s. They were destined to change the world—and lose their investors a truckload of money. Where did investors go wrong? They forgot the maxim that price matters. If you pay too much for a stock, you’ll likely make little or no money, no matter how great the company.

The converse is also true. Distressed companies can be great investments. Yes, some go bankrupt, but many times the best investments are found in the trash heap of companies that are widely shunned by investors. Tobacco stocks turned out to be great performers, despite the huge cloud of litigation hanging over them in the 1990s. Because these were “untouchable” stocks, their valuations fell to such bargain levels that they became wonderful investments.

7. Reversion to the mean is real. If the human brain has an Achilles’ heel, it’s a lack of statistical intuition. Nowhere is this more evident in investing than in the phenomenon of reversion to the mean.

For example, we attribute mutual fund performance entirely to the skill of the fund manager when, in fact, chance plays a much larger role that we’d like to admit. Result: Investors rush to buy a mutual fund that’s outperformed for five or 10 years and yet the fund will likely underperform in the future, as the manager’s lucky streak ends.

Even more important, mean reversion plays a major role in the relative performance of asset classes. Here, the phenomenon has more to do with the financial laws of gravity than it does with chance. When one asset class outperforms another for many years, the former becomes more expensive than the latter. Think about how U.S. stocks have outpaced international shares over the past decade. The problem: With higher valuations come lower expected returns.

When investors throw in the towel on an asset class after a period of rotten results, they aren’t always blind to mean reversion. In many cases, they understand it, but they suffer a loss of will. Patience has its limits. Mean reversion is real and ultimately exerts itself, but its time horizon—often decades—is longer than many investors have patience for.

8. If you pay Cadillac prices, you’ll likely get a Honda Civic. In life, you generally get what you pay for. If you’re looking for the best lawyer in town, you know you’ll have to pay up. If you need brain surgery, you don’t bargain hunt. If you want to buy a Cadillac, you expect to pay Cadillac prices.

It’s natural to assume the same holds true in finance. If I want the best money manager to handle my investments, I’ll need to pay a premium for his or her services, right? Wrong. Another of the great investment paradoxes is that paying more generally leads to inferior results. Quite literally, you are paying Cadillac prices for a Honda Civic.

Let’s say that your objective is an 8% annual investment return. If you pay a money manager 1% of your portfolio’s value to handle your investments, she’ll need to earn 9% a year to deliver 8% to you. If instead you pay the same manager 2%, she must now earn 10%. Unlike any other profession, the more handsomely a money manager is compensated, the more difficult his or her job becomes.

If you’re going to be widely diversified across the market—which is a good thing—why handicap your results with high fees? You can get the same broad diversification by investing in low-expense index funds, which means getting similar returns but at a far lower cost. That should translate into better performance net of fees. You have bought a Cadillac for the price of a Honda Civic.

John Lim is a physician and author of “How to Raise Your Child’s Financial IQ,” which is available as both a free PDF and a Kindle edition. His previous articles include Ten Tips for 2021Evasive Action and My Bad. Follow John on Twitter @JohnTLim.

Do you enjoy HumbleDollar? Please support our work with a donation. Want to receive daily email alerts about new articles? Click here. How about getting our weekly newsletter? Sign up now.

Browse Articles

Subscribe
Notify of
13 Comments
Inline Feedbacks
View all comments
SanLouisKid
SanLouisKid
8 months ago

One good thing the Universal Life Insurance salespeople of the early 1980s did was show some amazing projections. They didn’t work out, but were attention grabbing compounding examples. The one they ran for me showed I would have $1,000,000 at age 72 by putting $100 a month in the policy. That was back when interest rate projections were very high. I didn’t buy the policy, but it did start me thinking.

Roboticus Aquarius
Roboticus Aquarius
8 months ago
Reply to  SanLouisKid

The thing about investing is that it is convoluted that almost anything you say about it is conditional. Thus, even a bad example can yield a good lesson! I’ve experienced that as well.

Munir Katul
Munir Katul
8 months ago

I found the article promoting the well-known adage of buying low and selling high-if at all. However, if an investment starts going south, how can you know at that time if it is a buying opportunity or is it time to unload it?

Jonathan Clements
Jonathan Clements
8 months ago
Reply to  Munir Katul

If you own individual securities, you have no assurance the stock is coming back. But if you own broadly diversified stock funds (hint: low-cost total market index funds), you can have a lot of confidence that your funds will eventually recover and move higher.

parkslope
parkslope
8 months ago

Isn’t the notion that downturns represent buying opportunities counter to the notion that you can’t time the market? One can only buy when there is a “sale” if one has available funds that aren’t already in equities, which implies that one might be leaving money on the table while waiting for a sell off. Is there research that has examined whether buying during “sales” is superior to a simple buy and hold approach?

corrupt
corrupt
8 months ago

Learned a hard lesson about diversification and am a better investor for it today.

greglee
greglee
8 months ago
Reply to  Munir Katul

You can’t know. But for the American stock market, in the past, you would have done well to treat it as a buying opportunity. I bought near the end of 2008, then again in March of last year. So far, so good.

ScubaSkier
ScubaSkier
8 months ago

When interest rates are ZERO as they are now, compounding over a lifetime still yields a 0 return

greglee
greglee
8 months ago
Reply to  ScubaSkier

How very true. The obvious moral is to buy stocks, so you don’t have to depend on interest. Isn’t that risky? Sure, but for the American stock market, it has not proved to be very dangerous, provided you don’t sell when there is a crash. I have gotten 12.46% returns annually from my mutual stock funds since 1992

Roboticus Aquarius
Roboticus Aquarius
8 months ago
Reply to  ScubaSkier

This is mostly incorrect:

If you invest only in cash you may have close to zero nominal return, and negative real return.

Bonds may have positive nominal returns, but close to zero real return. For the past 40 years, though, bonds generated real returns.

US Stocks have yielded 6.7% real return over the very long term. Some people think it will be a couple percentage points lower over the next decade, but it still seems likely to be positive.

Most people put some of their investments in all three, and generate positive real returns even over some of the worst investment periods. All you need is positive real returns to increase your purchasing power over time. Real returns of merely 3.5% annually will double your purchasing power in less than 20 years.

greglee
greglee
8 months ago

The momentum theory, which you favor in #2, and mean reversion theory, your #7, of stock prices generally give opposite recommendations. When prices are plunging, momentum leads you to sell your stocks to avoid the further losses you expect, while mean reversion leads you to buy more stocks, to take advantage of the future rise in prices you expect. Don’t believe momentum. You should revise your #2 discussion.

mark236
mark236
8 months ago

The better example of the power of compound interest is not the investor, but the borrower. Anyone that has felt the sting of high rate credit cards or payday lending understands compound interest. They believe the credit card issuers are getting rich from people that do not understand the power of compound interest. The math works on both sides.

Mr Moderate
Mr Moderate
7 months ago

Dr. Lim –
Such a wonderfully thought-out and well-balanced article! Definitely in my top 10 from Humble Dollar. Thank-you. I’m saving this one. Might I add one possible side-note about #8? Sometimes it’s good to be pound-wise rather than penny-fooli$h, as in the example of an investor with a cognitive impairment or an investor with perceived self-wisdom (50% of which may be incorrect) and blind spots about advanced issues like taxes.

Free Newsletter

SHARE