Search results for: Dunning Kruger

10 Tuesday AM Reads

My two-fer-Tuesday morning train reads:

• 4 Reasons Microsoft Wasted $26.2 Billion To Buy LinkedIn (Forbes) see also How Microsoft Thinks Office Can Help LinkedIn and Vice Versa (Bloomberg)
• The Most Pessimistic Bull Market in History Instead of chasing growth and profits, investors this year have bought into safety (WSJ)
• A Brief Introduction to Pro-Holocaust Twitter (The Atlantic) see also To Beat Anti-Semitic Trolls Online, Some Co-Opt Their Weapons and Mock Them (NYT)
• Dunning-Kruger Effect Explains Donald Trump’s Popularity (Politicosee also 100 greatest descriptions of Donald Trump’s hair ever written (Washington Post)
• The Cost Of The B-21 Bomber Is Secret For Security Reasons, Which Is Convenient (Foxtrot Alpha) see also How Senators Quietly Voted to Keep Bomber Costs Secret (Roll Call)

What are you reading?

Continues here

Americans Fall Out of Love with Owning Stocks

Before the Great Recession, almost two-thirds of Americans owned stocks. That number has since fallen to a little more than half, as you can see from the chart below:

 

This is an important development with ramifications for retirement planning, demographics and income inequality.

First, a little history: Since late in the last century, one of the defining developments of equity markets has been how new technology and competition democratized investing. We can trace this back even further, to May 1, 1975, when the brokerage industry had to stop charging fixed commissions and start competing on the basis of price.

Trading, research and market commentary moved online in the 1990s. Soon after, a large part of the adult population came to believe that: a) they should be in the market;  b) they had the skills to pick stocks and/or time markets; c) everyone was going to get rich. Recall the Discover brokerage commercial in which a tow-truck driver, who by implication had struck it rich in the market, owned an island-nation? In 60 seconds the ad captured all the giddiness and naivete of that era.

Call it the revenge of the Dunning-Kruger effect — that the least competent are the most certain of their skills. Reality long ago intruded on all that false confidence: The dot-com collapse, the housing boom and bust, the commodities rise and fall, the Great Recession, and then to add insult to injury, a tripling of equities since the March 2009 lows. These events have disabused most amateurs of their belief in their investing prowess. Is the rise of indexing and passive investing any surprise?

Just as many former renters briefly became homeowners during the housing boom, only to return to renter status, so too did many stock-market dabblers take what was left of their capital and go home. Sure, more than half of American households still own equities, but for most of those investors it’s a modest amount (and the other half owns precisely zero); about two-thirds of equity ownership is held in the top 5 percent of portfolios. The top 20 percent owns 85 percent of all financial assets, according to the Levy Institute; the Economic Policy Institute is even more specific at 87.2 percent. Income gains have been even more skewed toward the top.

The social ramifications of this are profound, though the implications for financial markets are more nebulous. For the most part, equity ownership has always been concentrated among the wealthy. Will increasing ownership concentration have an effect on markets? It might, though it isn’t clear how.

However, there are good reasons to be concerned about the decrease in market-participation rates:

  • The decline of equity ownership reflects a failure by too many Americans to save, which portends untold trouble amid the looming retirement of the baby boom generation.
  • Income inequality is a burgeoning issue in the U.S. (and globally). Declining rates of stock ownership are a possible sign that the chasm is widening; this might increase the possibility of social and political upheaval.
  • Politics and policy are being broadly influenced by a middle classthat sees itself falling behind and unable to catch up. Look no further than the present presidential elections for manifestations.

There is a corollary issue — stocks are primarily owned by people who tend to be wealthier, male and white. This is a topic worthy of another column entirely.

In the meantime, falling equity ownership may well point to very big problems down the road.

 

 

Originally: The Thrill Is Gone From Owning Stocks

10 Wednesday AM Reads

Our early morning train reads, brought to you directly without a middle man taking 10% of our links:

• The real reason the Fed is eager to raise interest rates now (Quartzsee also Onto The Next Question (Tim Duy’s Fed Watch)
• AUM Growth Is Hedge Funds’ #1 Goal (CIOsee also State Pensions Funding Gap: Challenges Persist (Pew Trusts)
• How To Tell Good Studies From Bad? Bet On Them (FiveThirtyEight)
• Are You Superstitious? Are You Stupid? (Bloombergbut see Dunning-Kruger in Groups (NeuroLogica)
• The Manual Gearbox Preservation Society: Do You Drive Stick? Fans of Manual Transmission Can’t Let Go (WSJ)

Catch my dulcet tones this am co-hosting Bloomberg Surveillance from 7 to 10 am.

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10 Wednesday AM Reads

Wakey wakey, time to shake & bakey. Your morning after the rout the day before train reads:

• Most Downloaded SSRN Paper Ever Is All About Market Timing – and it suggests investors should currently be in cash (Bloomberg)
• How Much Diversification is Necessary? (A Wealth of Common Sensesee also The economics of the stock market is simple really: buy and hold (The Independent)
• I Can’t Define Short-Term Silliness but, Like Justice Stewart, I Know It When I See It (AQRbut see 5 Forces Driving the Global Stock Selloff (Moneybeat)
• Economics Has Math Problem (BV)
• Lessons from Dunning-Kruger (NeuroLogica)

Continues here

 

Forecasting is Marketing . . .

It’s time to market forecasters to admit the errors of their ways
Barry Ritholtz
Washington Post, January 18, 2015

 

 

I come not to praise forecasters but to bury them.

After lo these many years of listening to their nonsense, it is time for the investing community — and indeed, the seers themselves — to admit the error of their ways. Most forecasters are barely cognizant of what happened in the past. And based on what they say and write, it is apparent (at least to this informed observer) that they often do not understand what is occurring here and now.

So there’s no reason to imagine that they have the slightest clue about the future.

Economists, market strategists and analysts alike suffer from an affinity for making big, frequently bold — and most often, wrong — pronouncements about what is to come. This has a pernicious impact on investors who allow this guesswork to infiltrate their thinking, never for the better.

I have been beating this drum for more than a decade. What say we finally put a fork in Prediction, Inc.?

There is a forecasting-industrial complex, and it is a blight on all that is good and true. The symbiotic relationship between the media and Wall Street drives a relentless parade of money-losing tomfoolery: Television and radio have 24 hours a day they must fill, and they do so mostly with empty-headed nonsense. Print has column inches to put out. Online media may be the worst of all, with an infinite maw that needs to be constantly filled with new and often meaningless content.

Just because the beast must be fed does not mean you must be dragon fodder. (More on this later.)

The other partner in this mutually beneficial dance is the financial industry. Forecasting is simply part of its marketing strategy. There are two principle approaches to meeting the media’s endless demand for unfounded guesses about the future. Let’s call them a) Mainstream and b) Outlier.

The Mainstream strategy is simple: Take the average annual change in whatever the subject at hand is and extrapolate forward a year. Voila! You have a mainstream forecast. If you are talking about equities, predict an 8 to 10 percent gain in the Standard & Poor’s 500-stock index. For economic data, project out the past 12 months forward. You can do the same for gross domestic product, unemployment, commodity prices, bonds, inflation, just about anything with a regularly changing data series. If you are feeling puckish, you can shade the numbers slightly up or down to separate your prediction ever so slightly from the rest of the pack — just to keep it interesting. As Lord Keynes once said, better to fail conventionally than succeed unconventionally.

A perfect example is the recent collapse in oil prices. Having completely missed the 50 percent drop that occurred over 2014, analysts are now tripping all over themselves to forecast $40, $30, $20 per barrel in 2015. Since their prior guesswork completely missed the biggest energy story in decades, why should any of us care about their current guesswork?

Then there is the Outlier approach, where a wildly un­or­tho­dox forecast is made. The prognosticator predicts the Dow Jones industrial average at 5,000 when it’s three times that, or hyper-inflation, or $10,000 gold, or a 1 percent yield on the 30-year treasury bond, or a collapse in the Federal Reserve’s balance sheet.

If it comes to pass, the forecaster is feted as a rock star. If not, most people forget. (Although some of us actually track these outlier forecasts). Those in the prediction industry are pernicious survivors. They understand how to play on the human psyche to great advantage. Like the cockroach, they adapt well to conditions of chaos or uncertainty.

There is a flaw in the human wetware that leads to a demand for even more (bad) predictions. The evolutionary propensity that humans suffer from is the desire for specific predictions from self-confident leaders.

This is demonstrated in a wealth of academic data about forecasting track records. Research has shown there is a high correlation between a forecaster’s appearance of self-confidence and believability. Unfortunately, there is an inverse correlation with accuracy, for reasons revealed by the Dunning and Kruger studies on metacognition and self-evaluation. Same with specificity: Studies show that the more precise a prediction, the more likely it will be believed, and the less likely it is to be right. These (and other) factors set up viewers to have the most faith in the people who are least likely to be right.

Perhaps the biggest issue of all is the most obvious: Human beings, in general, stink at predicting the future. All of you. History shows us that people are terrible about guessing what is going to happen — next week, next month, and especially next year.

Why is that? In my last column, I noted that people are error machines, a mess of biases and emotions. They seek out, read and remember only that which agrees with their thinking.The experts are no better than the public at large. Consider the comprehensive examination of expert forecasting performed by Philip Tetlock, professor of psychology and management at the University of Pennsylvania. “Expert Political Judgment” is the book that came out of a study of 28,000 forecasts made by hundreds of experts in a variety of different fields. His findings?“Surveying these scores across regions, time periods, and outcome variables, we find support for one of the strongest debunking predictions: it is impossible to find any domain in which humans clearly outperformed crude extrapolation algorithms, less still sophisticated statistical ones.”

In other words, expert forecasts are statistically indistinguishable from random guesses.

What should investors do instead of paying attention to these unsupported, mostly wrong, exercises in futility called forecasting? I suggest three simple things:

1) Have a well-thought financial plan that is not dependant upon correctly guessing what will happen in the future.

2) Have a broad asset allocation model that is mostly passive indexes. Rebalance once a year.

3) Reduce the useless, distracting noise in your media diet.

It is important for investors to understand what they do and don’t know. Learn to recognize that you cannot possibly know what is going to happen in the future, and any investment plan that is dependant on accurately forecasting where markets will be next year is doomed to failure.

Never forget this simple truism: Forecasting is marketing, plain and simple.

~~~
Ritholtz is chief investment officer of Ritholtz Wealth Management. He is the author of “Bailout Nation” and runs a finance blog, the Big Picture

15 Biases That Make You A Dumb Investor

I am off to Toronto, where I am presenting at the annual CFA forecasting dinner. (I am the counter-programming, which means I get to explain why you humans are so bad at forecasting.

From Morgan Housel, here are several cognitive biases that cause you to do dumb things with your money. Be sure to check out the entire article.

15 Biases That Make You Do Dumb Things With Your Money
1. Normalcy bias
2. Dunning-Kruger effect
3. Attentional bias
4. Bandwagon effect
5. Impact bias
6. Frequency illusion
7. Clustering illusion
8. Status quo bias
9. Belief bias
10. Curse of knowledge
11. Gambler’s fallacy
12. Extreme discounting
13. Ludic fallacy
14. Restraint bias
15. Bias bias

I like Nobel Prize winning cognitive psychologist Daniel Kahneman’s take on this: He once said, “I never felt I was studying the stupidity of mankind in the third person. I always felt I was studying my own mistakes.”

 

 

Source:
15 Biases That Make You Do Dumb Things With Your Money
Morgan Housel
Motely Fool, August 30, 2013   
http://www.fool.com/investing/general/2013/08/30/15-biases-that-make-you-do-dumb-things-with-your-m.aspx

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. This year’s markets have perplexed the best of them. Each week brings another event that sets up some confusing crosscurrent: call them reversals or head fakes or bear traps or (my personal favorite) the “fake-out break-out” – this is a volatile, trendless market has been unkind to Wall Street pros and Main Street investors alike.

Indeed, buy & hold investors have had more ups and downs this year than your average rollercoaster. The third and fourth quarters alone had more than a dozen market swings, ranging from 5 percent to more than 20 percent. Despite all of that action, the S&P 500 is essentially unchanged year-to-date. It doesn’t take much to push portfolios into the red these days.

Three Opponents in Investing

With markets more challenging than ever, individual 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. He likes to make you look a fool. Sell him shares at a nice profit, and he happily takes their prices so much higher you are embarrassed to even mention them again. Buy something from him on the cheap, and he will show you exactly what cheap is. And perhaps most frustrating of all, Mr. Market has no ego – he does not care about being right or wrong; he only exists to separate the rubes from their money.

Institutional Competitors

Yes, Mr. Market is a difficult opponent. But your 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.”

Ellis lays out the brutal truth: investing is a rough and tumble business. It doesn’t matter where these traders work – they may be on prop desks, mutual funds, hedge funds, or HFT shops – they employ an array of professional staff and technological tools to give themselves a significant edge. 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.

We Have Met the Enemy and They Is Us

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 of all three. It is more than time constraints, lack of discipline, and asymmetrical information that challenges you. The biggest disadvantage you have is that melon perched atop your 3rd opponent’s neck. It is your big ole brain, and unless you do something about it, it is going to lose all of your money for you.

See it? There. Sitting right behind your eyes and between your ears. That “thing” you hardly pay any attention to. You just assume it knows what it’s doing, works properly, doesn’t make too many mistakes. I hate to disabuse you of those lovely notions; but no, sorry, it 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.

Let me give you an example. Think of any year from 1990-2005. Off of the top of your head, take a guess how well your portfolio did that year. Write it down – this is important (that big dumb brain of yours cannot be trusted to be honest with itself). Now, pull your statement from that year and calculate your gains or losses.

How’d you do? Was the reality as good as you remembered? This is a phenomenon called selective retention. When it comes to details like this, you actually remember what you want to, not what factually occurred. Try it again. Only this time, do it for this year – 2011. Write it down.

Go pull up your YTD performance online. We’ll wait.

Well, how did you do? Not nearly as well as you imagined, right? Welcome to the human race.
This sort of error is much more commonplace than you might imagine. 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.

(Despite having taken numerous high-performance driving courses and spending a lot of time on various race tracks, I am only an average driver. I know this because my wife reminds me constantly.)

As it turns out, there is a simple reason for this. The worse we are at any specific skill set, the harder it is for us to evaluate our own competency at it. This is called the Dunning–Kruger effect. This precise sort of cognitive deficit means that areas we are least skilled at – let’s use investing decisions as an example – also means we lack the ability to identify any investing shortcomings. As it turns out, the same skill set needed to be an outstanding investor is also necessary to have “metacognition” – the ability to objectively evaluate one’s own abilities. (This is also true in all other professions.)

Unlike Garrison Keillor’s Lake Wobegon, where all of the children are above average, the bell curve in investing is quite damning. By definition, all investors cannot be above average. Indeed, the odds are high that, like most investors, you will underperform the broad market this year. But it is more than just this year – “underperformance” is not merely a 2011 phenomenon. The statistics suggest that 4 out of 5 of you underperformed last year, and the same number will underperform next year, too.

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. (Do any of these sound familiar to you?)

These kinds of errors seem to be hardwired in us. Humans have evolved to survive in competitive conditions. We developed instincts and survival skills, and passed those on to our descendants. The genetic makeup of our species contains all sorts of elements that were honed over millions of years to give us an edge in surviving long enough to procreate and pass our genes along to our progeny. Our automatic reactions in times of panic are a result of that development arc.

This leads to a variety of problems when it comes to investing in equities: our instincts often betray us. 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. The panic selling at market lows and greedy chasing as we head into tops are a reflection of these factors.

The sort of grinding market we had in 2011 only exacerbates investor aggravation, and therefore increases poor decision making. Facts and logic go out the window, and thinking gets replaced with naked emotions. We get annoyed, angry, frightened, frustrated – and that does not help returns. Indeed, our 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. We have cognitive deficits that are by-products of that. Much of our decision making comes with cognitive errors “secretly” built in. We are often unaware we even have these (for lack of a better word) defects. These cognitive foibles are one of the main reasons that, when it comes to investing, we humans just ain’t built for it.

We Are Tool Makers

But we are not helpless. These large mammalian brains of ours can do a whole lot more than merely overreact to stimulus. We think up new ideas, ponder new tools, and create new technologies. Indeed, our ability to innovate is one of the factors that separates us from the rest of the animal kingdom.

As investors, we can use our big brains to compensate for our known limitations. This means creating tools to help us make better decisions. When battling Mr. Market – as tough as any Cro-Magnon or sabre-toothed tiger – it helps to be able to make informed decisions coolly and objectively. If we can manage our emotions and prevent them from causing us to make decisions out of panic or greed, then our investing results will improve dramatically.

So stop being your own third opponent. Jiu jitsu yourself, and learn how to outwit your evolutionary legacy. Use that big ole melon for a change. You just might see some improvement in your portfolio performance.

Individual Investors Have Certain Advantages Over Institutions

One final thought. Smaller investors do not realize that they possess quite a few strategic advantages – if only they would take advantage of them. Consider these small-investor pluses:

• No benchmark to meet quarterly (or monthly), so you can have longer-term time horizons and different goals;
• You can enter or exit a position without impacting markets;
• There is no public scrutiny of your holdings and no disclosures required, so you don’t have to worry about someone taking your ideas;
• You don’t have to limit yourself to just the largest stocks or worry about position size (this is huge);
• Cost structure, fees, and taxes are within your control;
• You can reverse errors without professional consequences – you don’t get fired for admitting a mistake;
• You can have longer-term time horizons and different goals;

And with those thoughts, good luck and good trading in 2012!

~~~

This was originally published as part of a longer piece in Thoughts from the Frontline exactly one year ago, on January 25, 2012.

 

WaPo: Why don’t bad ideas ever die?

Why don’t bad ideas ever die?
Barry Ritholtz,
Washington Post December 16, 2012

 

 

“The purpose of studying economics is not to acquire a set of ready-made answers to economic questions, but to learn how to avoid being deceived by economists.” — Joan Robinson

 

This time of year is filled with retrospectives and “best of” lists. I’d prefer a more enlightened discussion about bad ideas. Or rather, zombie ideas: the memes, theories and policies that refuse to die, despite their obvious failings. Why do we embrace the terrible, fall in love with the wrong, bet money on the fictitious? Nowhere is this truer than in the fields of economics and investing. Together they have produced a long list of thoroughly debunked ideas. Despite this, many of these zombie ideas still have a vice grip on amateurs and professionals alike. What is it about us and this intellectual voodoo? We keep repeating the same mistakes over and over. It is maddening. Let’s count the ways:

1 Shareholder value: Since the early 1980s, this theory had claimed that corporate management should concentrate primarily on increasing share prices. In practice, it is fraught with problems: Short-term focus on quarterly earnings leads to a decline in long-term research and development, typically to the detriment of a company’s long-term prospects. Short-termism and stock-option compensation causes management to focus on immediate quarterly returns. It has also led to earnings “management,” accounting fraud and a raft of management scandals. Shareholders derive much less value than the name implies.

2 Homo economicus: A primary principle underlying classical economics, it states that humans are rational, self-interested actors possessing an ability to make objective, intelligent judgments about matters of investing and money. This turns out to be hilariously wrong. We are all too often irrational, frequently emotional and regularly engage in behaviors that work against our self-interest. Homo economicus? Try Nogo economicus.

3 Economics as a science: Consider how wrong the economics profession has been about, well, nearly everything: They misunderstood the risks of derivatives; economists developed models that assumed home prices would not fall (!). They misunderstood why the recovery from the 2001 recession produced so few jobs or why the current recovery was worse in so many ways. Oh, and despite myriad signs, they missed the worst recession since the Great Depression even as it was on top of them. The sooner they admit that their field is not a hard science, the better off we all will be.

(more…)

Your Three Investing Opponents

Your Three Investing Opponents
By John Mauldin
December 24, 2011

~~~

Tough Year!
Three Opponents in Investing
We Have Met the Enemy and They Is Us
We Are Tool Makers
Individual Investors Have Certain Advantages Over Institutions
We All Need a Coach
Hong Kong, South Africa, Stockholm, and More

It’s Christmas Eve and that time of year when we start thinking about what we did in the past year and what we want to do in the next. Why do we make the mistakes we make (over and over and over?) and how do we avoid them in the future? If it seems to be part of our basic human condition, that’s because it is. Recently I have been having a running conversation with Barry Ritholtz on the psychology of investing (something we both enjoy discussing and writing about). Since I am busily researching my annual forecast issue (and taking the day off), I asked Barry to share a few of his thoughts on why we do the things we do. He gives us even more, exploring the three main opponents we face when we enter the arena of investing.

Barry is the driving force behind The Big Picture blog, often cited as the #1 blog site in terms of traffic (and a favorite of mine!) and FusionIQ, a software service that uses both fundamental and technical analysis. Over the years Barry and I have known each other, we have become quite good friends. If you ever get a chance to catch us on a panel together, you are in for some fun, as we tend to go at it and each other just for the heck of it, while trying to share the little that we have learned along the way. Barry is all over financial TV and now has a weekly column in the Washington Post. And now, let me turn it over to Barry.

Your Three Investing Opponents

By Barry Ritholtz

“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. This year’s markets have perplexed the best of them. Each week brings another event that sets up some confusing crosscurrent: call them reversals or head fakes or bear traps or (my personal favorite) the “fake-out break-out” – this volatile, trendless market has been unkind to Wall Street pros and Main Street investors alike.

Indeed, buy & hold investors have had more ups and downs this year than your average rollercoaster. The third and fourth quarters alone had more than a dozen market swings, ranging from 5 percent to more than 20 percent. Despite all of that action, the S&P 500 is essentially unchanged year-to-date. It doesn’t take much to push portfolios into the red these days.

Three Opponents in Investing

With markets more challenging than ever, individual 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. He likes to make you look a fool. Sell him shares at a nice profit, and he happily takes their prices so much higher you are embarrassed to even mention them again. Buy something from him on the cheap, and he will show you exactly what cheap is. And perhaps most frustrating of all, Mr. Market has no ego – he does not care about being right or wrong; he only exists to separate the rubes from their money.

Yes, Mr. Market is a difficult opponent. But your 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.”

Ellis lays out the brutal truth: investing is a rough and tumble business. It doesn’t matter where these traders work – they may be on prop desks, mutual funds, hedge funds, or HFT shops – they employ an array of professional staff and technological tools to give themselves a significant edge. 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.

We Have Met the Enemy and They Is Us

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 of all three. It is more than time constraints, lack of discipline, and asymmetrical information that challenges you. The biggest disadvantage you have is that melon perched atop your 3rd opponent’s neck. It is your big ole brain, and unless you do something about it, it is going to lose all of your money for you.

See it? There. Sitting right behind your eyes and between your ears. That “thing” you hardly pay any attention to. You just assume it knows what it’s doing, works properly, doesn’t make too many mistakes. I hate to disabuse you of those lovely notions; but no, sorry, it 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.

Let me give you an example. Think of any year from 1990-2005. Off of the top of your head, take a guess how well your portfolio did that year. Write it down – this is important (that big dumb brain of yours cannot be trusted to be honest with itself). Now, pull your statement from that year and calculate your gains or losses.

How’d you do? Was the reality as good as you remembered? This is a phenomenon called selective retention. When it comes to details like this, you actually remember what you want to, not what factually occurred. Try it again. Only this time, do it for this year – 2011. Write it down. Go pull up your YTD performance online. We’ll wait.

Well, how did you do? Not nearly as well as you imagined, right? Welcome to the human race.

This sort of error is much more commonplace than you might imagine. 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.

(Me personally, I am not an above-average driver. This is despite having taken numerous high-performance driving courses and spending a lot of time on various race tracks. I know this is true because my wife reminds me of it constantly.) [JM here – I am also in the bottom 25%, as my kids constantly remind me!])

As it turns out, there is a simple reason for this. The worse we are at any specific skill set, the harder it is for us to evaluate our own competency at it. This is called the Dunning–Kruger effect. This precise sort of cognitive deficit means that areas we are least skilled at – let’s use investing decisions as an example – also means we lack the ability to identify any investing shortcomings. As it turns out, the same skill set needed to be an outstanding investor is also necessary to have “metacognition” – the ability to objectively evaluate one’s own abilities. (This is also true in all other professions.)

Unlike Garrison Keillor’s Lake Wobegon, where all of the children are above average, the bell curve in investing is quite damning. By definition, all investors cannot be above average. Indeed, the odds are high that, like most investors, you will underperform the broad market this year. But it is more than just this year – “underperformance” is not merely a 2011 phenomenon. The statistics suggest that 4 out of 5 of you underperformed last year, and the same number will underperform next year, too.

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. (Do any of these sound familiar to you?)

These kinds of errors seem to be hardwired in us. Humans have evolved to survive in competitive conditions. We developed instincts and survival skills, and passed those on to our descendants. The genetic makeup of our species contains all sorts of elements that were honed over millions of years to give us an edge in surviving long enough to procreate and pass our genes along to our progeny. Our automatic reactions in times of panic are a result of that development arc.

This leads to a variety of problems when it comes to investing in equities: our instincts often betray us. 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. The panic selling at market lows and greedy chasing as we head into tops are a reflection of these factors.

The sort of grinding market we had in 2011 only exacerbates investor aggravation, and therefore increases poor decision making. Facts and logic go out the window, and thinking gets replaced with naked emotions. We get annoyed, angry, frightened, frustrated – and that does not help returns. Indeed, our 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. We have cognitive deficits that are by-products of that. Much of our decision making comes with cognitive errors “secretly” built in. We are often unaware we even have these (for lack of a better word) defects. These cognitive foibles are one of the main reasons that, when it comes to investing, we humans just ain’t built for it.

We Are Tool Makers

But we are not helpless. These large mammalian brains of ours can do a whole lot more than merely overreact to stimulus. We think up new ideas, ponder new tools, and create new technologies. Indeed, our ability to innovate is one of the factors that separates us from the rest of the animal kingdom.

As investors, we can use our big brains to compensate for our known limitations. This means creating tools to help us make better decisions. When battling Mr. Market – as tough as any Cro-Magnon or sabre-toothed tiger – it helps to be able to make informed decisions coolly and objectively. If we can manage our emotions and prevent them from causing us to make decisions out of panic or greed, then our investing results will improve dramatically.

So stop being your own third opponent. Jiu jitsu yourself, and learn how to outwit your evolutionary legacy. Use that big ole melon for a change. You just might see some improvement in your portfolio performance.

Individual Investors Have Certain Advantages Over Institutions

One final thought. Smaller investors do not realize that they possess quite a few strategic advantages – if only they would take advantage of them. Consider these small-investor pluses:

• No benchmark to meet quarterly (or monthly), so you can have longer-term time horizons and different goals
• You can enter or exit a position without impacting markets.
• There is no public scrutiny of your holdings and no disclosures required, so you don’t have to worry about someone taking your ideas.
• You don’t have to limit yourself to just the largest stocks or worry about position size (this is huge).
• Cost structure, fees, and taxes are within your control.
• You can reverse errors without professional consequences – you don’t get fired for admitting a mistake.
• You can have longer-term time horizons and different goals.

And with those thoughts, good luck and good trading in 2012!

We All Need a Coach

John here. As long-time readers know, I typically suggest that readers find a professional to help them with their investments, as doing it on your own takes time and a certain emotional mindset. Most of us (myself included) don’t have it. But some of you do have the mindset or desire and just need some help. One way to get help is to find a tool, as Barry talked about, that helps you have some objectivity about your stock-picking decisions.

Quick commercial: Barry has developed such a tool for professionals: IQ Trader. I asked him to do a less complicated, less expensive version for my readers. It ranks 8,000 stocks and ETFs and gives specific buy-sell signals based on your criteria. What I like about it is that it uses both fundamental and technical analysis to develop those signals. Fusion IQ puts powerful quantitative tools into the hands of the average active trader. This can be of enormous assistance for the individual investor who wants an objective measure of stocks and sectors.

There’s no math, only easy to use tools. All of the heavy algorithmic calculations are hidden from view. Subscribers get a straightforward system to monitor their portfolios, and easily track potential names in their watch list. Fusion IQ’s email alerts let you know when a stock you are considering reaches predetermined parameters.

Long-term investors who suffered through the downturn in 2007-08 will appreciate the risk-management tools Barry has developed. You can easily keep tabs on your portfolio holdings, as they are monitored for both fundamental and technical changes in character. The Fusion IQ software also monitors and ranks the different sectors of your holdings.

If you would like to learn more or get a subscription, my readers are the first to see the new Fusion IQ Investor site. At $29.95 per month, you get a powerful system to help you manage your portfolio and investing activity. If you are not completely happy, cancel within 30 days for a no-questions-asked, unconditional, full refund. You can learn more at https://www.fusioniqinvestor.com/. I encourage those of you who want to more successfully manage your portfolio and trades to take a look.

Hong Kong, South Africa, Stockholm, and More

It is Christmas Eve tonight, and the kids and friends will be gathering. It is always a good time to sit and enjoy my family. I will go and see my 94-year-old mother this afternoon, as she won’t be able to come for Christmas dinner as usual. Seems she was at church and thought there was a chair underneath her and sat down, only to find there was nothing but hard floor, and she broke her tailbone. She is in a great deal of pain if she moves, so it is best for her to stay in bed while she heals.

My daughter Abbi has let me know she wants to go to the Mavericks game on Christmas Day; and since it is an early afternoon game, dinner will be in the late afternoon. I will set the prime to roasting at a very low temperature so it will not overcook, and then go and watch them raise the NBA Championship pennant for the first time in Dallas. I have been a season ticket holder for about 30 years (since they first came here) and it has been a long, long time to wait for a championship.

Next year is already shaping up to be another year for traveling. I will be speaking in Hong Kong and Singapore in January; Capetown, South Africa in February; and Stockholm, Sweden in March. And all sorts of places in the US, as the schedule starts to take shape.

Have a very blessed Christmas and holiday time. I have a very special letter planned for next week to start you off right for 2012, and then my own forecast will be out on January 5. So much to read and think about. Have a great week!

Your wondering where the year went analyst,

John Mauldin

John@FrontlineThoughts.com