Barry Ritholtz
Barry Ritholtz
Columnist

Pinocchio traders with fantastic returns are lying to themselves

Michael: I don’t know anyone who could get through the day without two or three juicy rationalizations. They’re more important than sex.

Sam: Ah, come on. Nothing’s more important than sex.

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Michael: Oh yeah? Ever gone a week without a rationalization?

— “The Big Chill” (1983)

In my last column, we discussed my annual rite of Mea Culpa. That’s where I look back at the prior year to evaluate what I got wrong and why. It is a humbling experience designed to make me a better investor, and I have been doing it — in public — for several years. Numerous readers have told me that this is a rarity in the world of finance.

But every year I hear from a small segment of active traders who misread what the discussion is about, seeing it as an invitation to brag about their best trades. Astonishingly, these e-mailers have all significantly outperformed the markets over the years, putting up fantastic return numbers. They never seem to have a losing trade. They sold Apple at exactly $705 and bought gold precisely at the bottom. Even more amazingly, they got out at the market top in October 2007 and bought in at the exact lows in March 2009.

The polite term for these people is “fibbers.” Personally, I say it’s lying.

Mathematical probabilities make these claims of uniformly spectacular track records extremely unlikely. And what I find most intriguing is that these Pinocchio traders (as I call them) are not really lying to you or me, but, rather, to themselves.

Little white lies are told by humans all the time. Indeed, lying is often how we get through each day in a happy little bubble. We spend time and energy rationalizing our own behaviors, beliefs and ­decision-making processes.

As investors, we want to believe we are smart, insightful and uniquely talented — even though we often fail to do the heavy lifting, put in the long hours, and make the uncomfortable but necessary decisions to achieve success.

But self-deception is especially costly when it comes to investing. So let’s consider some of the lies that a lot of you may be telling yourselves and the impact they may have on your portfolios.

You know what your investment returns are. You would be surprised at how few people actually know what their returns are. Even fewer understand their performance relative to a benchmark.

According to a study of online investors by Markus Glaser and Martin Weber, “The correlation coefficient between return estimates and realized returns is not distinguishable from zero.” In other words, what we think our investment returns are and what they actually are have literally nothing to do with each other.

It is not that complicated to correct this. Set up a simple spreadsheet using Microsoft Excel or Google Drive or one of the available online tools. Keep careful records of your portfolios, cumulative and YTD returns, and you will avoid the “performance delusion.”

You can predict the future. You may not say you believe you can forecast what will happen next year, but you certainly behave that way.

Whenever you try to pick market tops and bottoms, you are making a prediction. Guessing what stock is going to outperform the market is forecasting, as is selling a stock for no apparent reason. Indeed, nearly all capital decisions made by most people are unconscious predictions.

We’ve discussed this many times, but it bears repeating: No one can consistently predict the future with any degree of accuracy. If your investing approach requires that you become Nostradamus to succeed, then you are destined to fail.

You know how costs, fees and taxes impact your returns. Not too long ago, an acquaintance was bragging about what a great year he was having. And truth be told, his gross returns were impressive.

Then I had him calculate his net returns. Once he figured in his turnover, commissions and especially taxes, he realized he had an enormous cost structure that ate into his P&L. After all costs, his great gross returns turned into below-market returns.

I informed him, “My retired 75-year-old mom bought an S&P 500 index last January, paid an $8 commission and forgot about it for the year. She kicked your professional butt.” He was not happy about that.

Perhaps we need a corollary rule about active trading: Gross returns don’t count, net returns do.

You can pick fund managers. Yes, we all know who the great fund managers of the past 20 years were, but that’s after the fact. What makes you think you have the skill set to evaluate the best ones of the next 10 to 20 years — their investing approach, discipline, character and ability to express their investing thesis?

Only 1 percent of fund managers actually earn their fees: Why do you believe that you can pick them out?

You understand mean reversion. Every year, it seems, some fund manager gets the hot hand and becomes a media darling. He attracts lots of assets as investors chase past performance. The size of his fund balloons. Then the disappointments come.

Here’s why. Outperformance is often random among the 20 percent who manage to do better than their benchmark each year. But it’s always a different 20 percent. Following that run of good fortune, they typically follow with a subpar year, as their chosen style or sector cools off — it reverts to the mean, or average. (Math is a cruel mistress.)

You have a plan. I am constantly astonished at how few people actually have any sort of long-term plan other than throwing some money into a 401(k) or IRA and hoping for the best.

You can pick stocks. Let’s be brutally honest about this: Discussing specific stocks during a bull market is loads of fun. Chatting about new products, management and exciting new technologies makes for great cocktail party chatter.

The problem is that most of you lack the specific skill set to do this well. This includes understanding valuations, recognizing problems early and, perhaps most of all, following your discipline to limit losses when things don’t work out.

Most investors are better off owning a set of broad indexes for their main retirement accounts.

You are saving enough for retirement. I’ll spare you the lecture, but for most of you this is not true.

The average retirement account held by 60 percent of Americans is less than $25,000 (according to the Employee Benefit Research Institute). The average 401(k) is $77,300 (Fidelity). According to EBRI, only 14 percent of American workers are very confident they will have enough money to live comfortably in retirement.

This has been a short list. As Mark Twain wrote: “Everybody lies — every day; every hour; awake; asleep; in his dreams; in his joy; in his mourning.”

What are you lying to yourself about?

 
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