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Ritholtz: Here's Why Most Investors Are Guaranteed To Lose

Barry Ritholtz:

Here's Why Most Investors Are Guaranteed To Lose: Your Three Investing Opponents: Tough Year!” We hear that around the office nearly every day – from professional traders to money managers to even the ‘most-hedged’ of the hedge fund community....

[I]ndividual investors need to understand exactly whom they are going up against when they step onto the field of battle. You have three opponents to consider whenever you invest. The first is Mr. Market himself. He is, as Benjamin Graham described him, your eternal partner in investing. He is a patient if somewhat bipolar fellow. Subject to wild mood swings, he is always willing to offer you a bid or an ask. If you are a buyer, he is a seller – and vice versa. But do not mistake this for generosity: he is your opponent....

[Y]our next rivals are nearly as tough: they are everyone else buying or selling stocks. Recall what Charles Ellis said when he was overseeing the $15-billion endowment fund at Yale University: "Watch a pro football game, and it's obvious the guys on the field are far faster, stronger and more willing to bear and inflict pain than you are. Surely you would say, 'I don't want to play against those guys!' “Well, 90% of stock market volume is done by institutions, and half of that is done by the world's 50 largest investment firms, deeply committed, vastly well prepared – the smartest sons of bitches in the world working their tails off all day long. You know what? I don't want to play against those guys either."... With billions at risk, they deploy anything that gives them even a slight advantage. These are who individuals are doing battle with. Armed only with a PC, an internet connection, and CNBC muted in the background, investors face daunting odds. They are at a tactical disadvantage, outmanned and outgunned....

That is even before we meet your third opponent, perhaps the most difficult one to conquer of all: You. You are your own third opponent. And, you may be the opponent you understand the least.... The biggest disadvantage you have is that melon perched atop your 3rd opponent’s neck.... [I]t does not work nearly as well as you assume. At least, not when it comes to investing. The wiring is an historical remnant, hardly functional for modern living. It is overrun with desires, emotions, and blind spots. Its capacity for cognitive error is nearly endless. It was originally developed for entirely other purposes than risk assessment in capital markets. Indeed, when it comes to money, the way most investors use those 100 billion neurons or so of grey matter, they might as well not even bother using their brains at all....

If we ask any group of automobile owners how good their driving skills are, about 80% will say “Above average.” The same applies to how well we evaluate our own investing skills. Most of us think we are above average, and nearly all of us believe we are better than we actually are.... The worse we are at any specific skill set, the harder it is for us to evaluate our own competency at it....

Underperformance is not a disease suffered only by retail investors – the pros succumb as well. In fact, about 4 out of 5 mutual fund managers underperform their benchmarks every year. These managers engage in many of the same errors that Main Street investors make. They overtrade, they engage in “groupthink,” they freeze up, some have been even known to sell in a panic....

To do well in the capital markets requires developing skills that very often are the opposite of what our survival instincts are telling us. Our emotions compound the problem, often compelling us to make changes at the worst possible times.... [O]ur evolutionary “flight or fight” response developed for a reason – it helped keep us alive out on the savannah. But the adrenaline necessary to fight a Cro-Magnon or flee from a sabre-toothed tiger does not help us in the capital markets. Indeed, study after study suggests our own wetware works against us; the emotions that helped keep us alive on the plains now hinder our investment performance. The problem, as it turns out, lies primarily in those large mammalian brains of ours. Our wiring evolved for a specific set of survival challenges, most of which no longer exist...

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