Investing or Gambling?

Rats vs. Humans:

An intriguing behavioral study completed in 2002 illustrated how humans sabotage themselves in the investing game. Researchers used both a human study group and a rat study group to determine the accuracy of their ability to predict whether a green or red light would flash. The humans earned a point when they correctly guessed red or green, while the rats received a mild electric shock if they were wrong and a treat if they were correct.

The lights appeared in a random sequence but with a fixed probability, so that green appeared more frequently (around 80%) and red less frequently (about 20%). The rats soon learned to maximize their rewards by always guessing green, securing a correct prediction rate of 80%. The rats simply accepted the error rate and suffered the mild electric shock 20% of the time.

Humans, on the other hand, tried to guess the pattern by switching between green and red in an attempt to predict the light pattern—think gambling. As a result, the humans’ success rate only reached 68%. By attempting to predict a complex pattern where none existed, humans significantly underperformed the rats.

Recognizing patterns was an advanced survival skill/trait developed by early humans that helped them succeed in severe conditions. It allowed them to find food and avoid areas where predators were likely lurking. Seeing patterns in random events, however, is now a fairly common problem today. The tendency to find patterns in totally random events is called apophenia or patternicity. Extreme cases of recognizing patterns where none exist can be a sign of serious mental illness such as schizophrenia.

Less Gambling and More Investing:

The behavioral trait demonstrated in the above study—our tendency to look for patterns in random or near-random processes—illustrates why many people are dedicated to stock picking. We often believe that if we do enough research or follow market indicators correctly, we can predict the next big move. However, just like the participants in the study who kept guessing red lights instead of simply sticking to green, we sabotage ourselves and our long-term goals by constantly buying and selling stocks in an attempt to “beat” the market.

Researchers Daniel Kahneman and Amos Tversky have studied overconfidence and loss aversion behaviors in finance. They found that we tend to overestimate our predictive abilities and undervalue the role of randomness in the stock market. Our overconfidence typically leads to excessive trading, which racks up fees and diminishes our returns. Additionally, our loss aversion typically drives us to sell our stocks prematurely when they dip in value—even if the drop is short-term—rather than hold steady as typical index investors do, who rarely mess with their investments.

Eugene Fama’s Efficient Market Hypothesis supports the idea that it is extraordinarily difficult to “beat the market” with any long-term consistency. The short-term direction of the stock market, either upward or downward, is random. So many factors impact investor sentiment, that it is impossible for anyone, despite claims to the contrary, to predict stock market directions in the short term.

Studies by the S&P and the Dow revealed that the most active fund managers underperform their benchmarks over the long term—just as gamblers eventually fall victim to their game of chance’s odds over the long haul. Even the legendary Warren Buffett has famously challenged active managers to beat a simple S&P 500 index fund over a multi-year span—and most managers failed to do so.

Wrap-Up

In the world of personal finance, few debates have been as persistent or as passionate as the one between investing in index funds versus picking individual stocks. Stock pickers are certain they can “beat the market” returns and really enjoy the exhilaration of finding the next big winner. In contrast, index fund investing is very boring, but creates long-term consistency and broad diversification at the lowest cost possible. In reality, a growing body of research shows us that index fund investing is almost always superior to stock picking. Once purchased, holding investments long-term also helps boost returns. As crazy as it seems, the less we fiddle with our investments, the better they perform.

Larry and Lisa Faulkner