Focus On The Long Term
Ever thought you were better than most people at something? Like bargain shopping, driving, or cooking? It turns out that we humans all tend to think we’re above average in some situations where we’re likely just average (or worse!). This tendency is called the “overconfidence bias,” and it’s one of the many psychological biases that all we humans share. And Investing is no different from those other skills we inflate – many people think they can earn above-average returns through their superior abilities (despite much evidence to the contrary). The reality is that trading is hazardous to your wealth, and studies have shown that active stock-pickers generally perform worse than passively selected index funds that track market averages. Many people think they can outperform the market, but they rarely do in the long term.
The Problem with Picking a Picker: Active Management is a Losing Game
Now, you may be thinking, what if I find a certifiably brilliant stock picker and put my money with her? While there may be some brilliant stock pickers out there, it’s just as hard to pick a good picker as it is to pick a good stock. Past performance is not a good indicator of future returns, so when people look at strings of recent stock-picking performance to choose a money manager, they’re likely to be disappointed when it turns out that their manager is just average (or worse!). In fact, after subtracting fees, the average active stock picker under-performs index funds.
And think about this: every individual or professional picking stocks is competing against millions of people in the market, every one of them thinking they can win, as well as against the behemoth stock-picking infrastructures at well-funded hedge funds and investment banks. These wealthy firms have computers and full-time analysts looking at massive amounts of data and seeking to exploit human psychological biases, making it harder now than ever for the average investor to beat the market.
How to Maximize Earnings Potential: Passively Managed Index Funds
Fortunately, there is a way to take human biases out of the equation and capture at least the average of stock and bond returns. The best way to do this is to invest in index funds. They are often referred to as “passive” investing, because they don’t rely on “active” trading decisions for their performance. Instead, they are based on purchasing a little bit of every company in an indexed sector (such as all tech stocks, all big US companies, etc.) You win some, you lose some, but because you’ve spread your investment across lots of companies in a balanced, non-biased way, you’re likely to make money over the long term. Betterment invests you in a type of index fund called an Exchange-Traded Fund (ETF). These are index funds with liquidity, tax, and cost advantages over mutual funds.
The SEC notes the historical advantage of index funds: “Historical data shows that index funds have, primarily because of their lower fees, enjoyed higher returns than the average managed mutual fund.” That’s why we’ve focused instead on choosing the very best basket of index funds – the ETFs that compose Betterment’s stock market portfolio. Our investors still get the value of experts deciding where to put their money – it’s just that we’re using our expertise where it has real positive impact.
Other Common Investor Pitfalls
Betterment’s simple approach is not only a more efficient use of your time–it’s also a smarter way to achieve better long-term returns–because it helps you overcome some common behavior biases.
People didn’t evolve to make investments, they evolved to do the basic things necessary to survive and procreate. So our instincts sometimes aren’t optimized for investing. One example of a behavioral bias is that we tend to go with what’s most familiar to us (like a company who’s name we know or who we work for), rather than properly diversifying. Massimo Massa and Andrei Simonov, of INSEAD and the Stockholm School of Economics, respectively, write:
“There is a ‘general tendency of people to have concentrated portfolios… [and] hold their own company’s stock in their retirement accounts…. Together, these phenomena provide compelling evidence that people invest in the familiar while often ignoring the principles of portfolio theory’.”
In many areas of life, the familiar is important to our decision making–but in investing, going with what we know can send us on a path that diverges greatly from the most effective way to manage a portfolio.
There are a host of other ways your investing decisions might be influenced without you realizing, several of which are described by Alistair Byrne and Mike Brooks here. For instance, people have a tendency toward representativeness, meaning they invest based on recent performance rather than fundamentals. And people are prone to conservativism, which in Byrne and Brook’s paper means that they cling to their beliefs in the face of new information (like information that a stock might go down, when they were sure it would go up). Even investors who think they are taking a less risky approach by investing in mutual funds are vulnerable to behavioral biases, according to various studies including one from financial research firm Dalbar.
So, how do you avoid falling victim to behavioral biases that can take your portfolio off the road to long-term growth? The answer is fairly simple: take yourself out of the equation. If you remove yourself from the process of choosing assets, you remove the possibility that you’ll be influenced by factors like the ones described above. You’ll be less tempted to chase winners, because the stock picking is already done for you. And if you set up automatic deposit, which we encourage you to do, you’ll be less likely to move money into your account at inopportune times. These safeguards are part of what led us to making the Betterment model as simple as possible – yes, we want to save you time and energy, but we also are protecting our customers from common investing pitfalls.