By: Evan Meyers
If you have ever received an investing tip from the media, a friend, or even a family member and think you may be able to “beat” the market, you are not alone.
Let’s start by defining a common investing bias called “Hindsight Bias.” It is described as a psychological phenomenon in which individuals tend to overestimate their own ability to have predicted an outcome that they would have been unable to predict before. We have all fallen victim to this before. As an example, in the realm of investing, you pick a few different stocks to put some money into. One of those stocks happens to have a 10% surge in price, and all you can think is, “I knew it!” You are convinced that you had a step up on the market, and you are just naturally a great investor.
Not So Fast
Now, I am not calling you a bad investor, but the truth is we typically remember the investments that have done well and forget about the ones that have not done as well. If you are at a get together catching up with some friends, you do not hear, “I lost 2% in STOCK X over the past year.” That is not exciting or something anyone wants to share with others. You may, however, hear “I nailed Stock Y this year and am up 20%.” Then you think to yourself, why is my portfolio not earning 20%. If you are a disciplined investor and own a diversified portfolio, this applies because all you hear about is how great the US Market returns have been. If you own a diversified portfolio consisting of Fixed Income and Equities (both Domestic and International), you may be up a healthy amount depending on your allocation. Still, it never sounds as good as the best performing asset class.
Life on the Edge
The excitement of owning an individual stock may be more alluring than the more passive nature of purchasing Mutual or Index funds, but the question is, do you know something the market doesn’t that will allow you to be a successful active investor? Let’s break this thought down further.
Anytime you are buying a stock; the current stock price reflects the perceived value of that stock at that exact moment in time. The market is made up of millions and millions of investors that are making buy and sell decisions based on information and data. If you are purchasing a stock, this price is actively moving during trading hours based on readily available information. Especially in a day and age where technology and data travel fast, you can imagine how quickly public information is factored into a stock’s price. By the time you hear something on the TV, reading an article on Yahoo Finance, or getting that “stock tip” from a good friend, the information that is supposed to provide you excess return has most likely already been factored into the price.
A Real-World Example
Let’s walk through a real-life example of this. On February 14th, 2013, USA Today reported that “Heinz agrees to buyout by Berkshire Hathaway, 3G.” Below are two slides from Dimensional Fund Advisors that illustrates how the stock price and trade volume is immediately impacted. You will notice that the large vertical blue bar represents the increased trade volume that is reacting to this news. If you look closely, the stock price has already increased by the time the average investor is purchasing more shares based on this “new information.” All those investors are purchasing a stock at the heightened price, so they have already missed the excess return here.
The point of this is not to discourage anyone from investing. Investing is extremely important and vital for growing your wealth to plan for retirement. The point here is to show that the next time you think you have a step up on the market, ask yourself, do you have access to a public piece of information that millions of others do not? The easy way to avoid continually reacting to the market, and missing out on return is to invest passively, invest in capitalism. Mutual funds and Exchange Traded Funds offer relatively low-cost access to own thousands of stocks to help build a diversified portfolio and invest in different markets.