Larry Swedroe Bemoans Investor’s “Magical Thinking”

By on March 1, 2012

Larry Swedroe, author of Investment Mistakes Even Smart Investors Make and How to Avoid Them, has written an enlightening and in-depth article entitled, “On Magical Thinking and Investing,” at

Swedroe is an advocate of investing in index funds and is a principal and the director of research of Buckingham Asset Management and BAM Advisor Services. He has written 10 other highly regarded books on investing.

Swedroe lays out his case as to why investors engage in self-destructive behavior, or as he puts it, “why do the majority of investors keep playing a loser’s game?”

1. The education system has neglected to provide the public a basic understanding of capital markets. Many investors obtain their “education,” or perhaps indoctrination, from the complex most likely to benefit from their ignorance, that being Wall Street and the financial media.

2. Investors, for the most part, fail to educate themselves. As Swedroe puts it, “instead of reading books like mine or John Bogle’s or William Bernstein’s, they would rather watch CNBC — to hear some guru’s forecast — or some reality TV show.”

3. The emotional desire of investors to do better than the average. The financial complex preys on this thinking by promoting the idea investors can do better than the index, or average. Swedroe points out index funds provide “market returns,” and do it with lower costs and increased tax efficiency, therefore enabling investors to do better than the typical, average investor.

Swedroe attempts to explain investor’s behavior by quoting from Kathryn Schulz’s book, Being Wrong: Adventures in the Margin of Error, a far-reaching analysis of human error.   Swedroe’s comments are focused on the behavioral finance concept of overconfidence.

Swedroe also quotes from Margaret Heffernan, author of Willful Blindness: Why We Ignore the Obvious at Our Peril, highlighting her observation, “We mostly admit the information that makes us feel great about ourselves, while conveniently filtering whatever unsettles our fragile egos and most vital beliefs.”

Swedroe further questions why experts are so often wrong and destructive to their followers. For the answer, he quotes from David Freedman’s book, Wrong: Why experts* keep failing us–and how to know when not to trust them *Scientists, finance wizards, doctors, relationship gurus, celebrity CEOs, … consultants, health officials and more.

Freedman notes that a wide range of economists and even mathematicians, as well as many nonscientist financial experts, have been demonstrating quite clearly for about a century that no matter what technique you use to pick stocks, you’re not likely to beat the market; that “many of us still put our faith in, not to mention bet our life savings based on, the advice of, say, a screaming, bouncing, bell-ringing television personality who claims to have special insight into the movements of stocks, is, I think, a sharp illustration of how some experts can ride straight-out irrationality to great personal success.”

Swedroe points out investors want certainty and an expert that can provide it, even when no semblance of certainty exists. He says an excellent book by Philip Tetlock, Expert Political Judgment: How Good Is It? How Can We Know?, demonstrates professional economic forecasters can’t predict economic activity with any persistence.

Finally, Swedroe says many investors don’t know how their own actual returns compare to market benchmarks (indexes). He adds that they probably don’t want to know, but should so they can minimize self-destructive behaviors.

SMA Comment: Larry Swedroe is to be commended for his contributions to investor education. The views of many whom he would demonize are featured here, however, it is done to provide investors opposing viewpoints, stock market statistical information, and serve as a historical reference as to the accuracy of the “experts” highlighted. Taking action based on guru predictions and forecasts is never endorsed, as they have proven to be highly fallible.

Source:  IndexUniverse

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