5 cognitive and emotional errors, followed by three expressive and emotional benefits:
- They forget that trading is competitive. (Cognitive Error)
Statman suggests the first mistake that investors make is a so-called framing error. Specifically, investors assume that trading is analogous to an activity such as plumbing. A plumber’s work improves the more experienced he or she becomes. But the analogy with investing is flawed because “pipes and fittings do not compete against the plumber, inducing her to choose the wrong fitting,” Statman writes. A trader, on the other hand, “always faces a competing trader on the other side of his trade, sometimes inducing him to choose the wrong trading strategy .”
Declaimer: This article was originally in February 2020 and some of the data points may be outdated.
- They don’t compare their returns to the market. (Cognitive Error)
This is another framing error. Many investors, Statman says, frame their returns relative to zero, rather than relative to the market return—the performance they could have earned by investing in a low-cost index fund. “A 15% annual return is excellent,” he says, “but it is inferior when an index fund delivers 20%.”
- They don’t properly calculate their returns. (Cognitive Error)
Another reason investors mistakenly believe that markets are easy to beat is that they tend to form a general impression of their results, instead of properly calculating them. This leads to confirmation errors, whereby they focus on the winners in their portfolio and overlook the losers. A study of amateur investors in the U.S., for instance, found that they overestimated their investment returns by an average of 3.4 percentage points.
- They’re fooled by small numbers. (Cognitive Error)
It’s reasonable, Statman suggests, to form an opinion of a restaurant on the strength of 10 visits: “Seven bad meals out of 10 or even two bad meals out of three might well be all we need for a general conclusion that it is best to forgo dining at that restaurant.” What makes trading different is the random nature of outcomes. Things can either go very well or very badly. A trader can enjoy a streak of wins, purely because of luck.
- They’re susceptible to availability errors. (Emotional Error)
The final error that Statman highlights is often referred to as availability bias. Investors tend to base their opinions on easily available information. Whether it’s someone at the local bar, a colleague at work, or a relative at a family gathering, we’ve all had conversations with people who claim to have profited greatly from buying a particular stock or fund. People who share these sorts of stories are often less inclined to disclose the bad investments they’ve made. The same applies to stories in the media. Generally, the funds that are written about are those which have outperformed.
- They like to gamble. (Emotional Benefit)
After articulating the above five errors, Statman focuses on what investors want. It’s well known that some of us enjoy gambling. Some keep gambling even when faced with large losses because they like the buzz so much.
There’s evidence that some investors are motivated by the same sort of enjoyment. For example, a 2018 study of 421 pump-and-dump schemes in Germany found that the average loss for investors was nearly 30%. Yet, some 11% of pump-and-dump investors participated in four or more schemes during the sample period.
- They enjoy it as they would a hobby. (Emotional Benefit)
It isn’t just the prospect of a big win that makes people try their hand at active trading. In one study, active investors in the Netherlands were asked about their motivations. More of them agreed with the statement “I invest because it is a nice free-time activity” than with the statement “I invest because I want to safeguard my retirement.” A study of amateur U.S. traders by Fidelity Investments found that more than half enjoyed learning new skills and sharing news of their wins and losses with friends and family.
- They think of themselves as better than average. (Emotional Benefit)
The final motivation for active trading, Statman argues, is the need to feel that we’re better than average. This need, he says, is reflected in the way that funds are marketed. He refers to two TV commercials, both for investment companies.
One denigrates index funds as average, and concludes with a man standing on a stage as a sign lights up: “Why invest in average?” In the second ad, the announcer asks, “If passive investing was called ‘don’t try,’ would you still be interested?” The irony: Index investing is, of course, a way of ensuring that you receive returns that outpace those of the typical investor.
