Monday, November 29, 2010

Don't Try to Pick Up Quarters Off the Street

I was walking on the street this weekend when I noticed a quarter on the ground. My initial thought was to pick it up...but then my knowledge about the stock market immediately kicked in. I suddenly couldn't decipher if I was having a deja vu, dreaming, or actually experiencing this! I thought to myself: If the world of walking the streets of Dallas is anything like the stock market that quarter shouldn't be there. Furthermore, even if it really was there, the action of bending over and picking it up would not overcome the costs (in this case energy and time) of receiving 25 cents. I quickly snapped out of my mental intuition and rightfully picked up the quarter. Oh well...

On the other hand, individual and professional investors believe they are all good at picking up quarters off of the ground or picking the next Microsoft or predicting interest rates or figuring out that international stocks will beat domestic. But they fail to realize two things, 1) those free quarters or opportunities do not consistently exist and 2)the cost of trying to find those quarters will dig you a deeper hole.

When talking to individual investors some feel they are the next stock picker dejour. Again, they fail to realize that there never was and never will be a stock picker dejour - someone who can predict the future and position their portfolio appropriately for the next 20-30 years, beating a portfolio of low-cost, diversified index funds.

One of the biggest mistakes an investor can make is believing that they have the "skill" or "knowledge" to outperform the market (perform better). Usually this conviction arises by looking in the rear view mirror while driving forward. Investors plow into funds after strong performance and depart after weak performance. Just because a fund has had great performance in the past does not mean it will continue to do so. Furthermore, once you invest in a fund you do not instantly achieve the past returns of the fund. If investing worked that way everyone would be rich.

An active manager attempts to outperform the market (index) by assembling a portfolio that is different than the market. They construct their portfolios through innumerable methods: account records, earnings, the CEO, rating services, the alignment of the stars, literally anything their brain can trick them into believing that a pattern or rationale exists for.

I have asked dozens of investors why they believe they have more information than millions of other market participants. I ask why they think they can outperform the market even though the odds (2 out of 10 each year) are against them. I ask why they think quarters are free. I have never gotten a response to this question.

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