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Why Do Investors Fail?

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Passive investors fall victim to a herd mentality, and active investors to the fatal conceit that they can beat the markets.

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In "Why Investors Will Almost Never Make It Big," I explained that perhaps the main reason investors fail is that their wealth is exposed to the vicissitudes of the market way too much and far too often.

In this article I will elaborate on that thesis, highlighting two contrasting reasons why investors tend to become overexposed to the markets, and why this tendency in both cases leads to failure.

The first reason is that many investors follow passive investment strategies that call for them to be fully invested at all times. The second reason is that investors/traders become overactive, thereby increasing their risk exposure.

Passive Strategies and Human Frailty

A passive investment strategy calling for traders to be fully invested in the market at all times has been promoted as an intelligent strategy for two reasons. The first is that the strategy acknowledges that markets are relatively efficient and that it's very difficult for individuals to consistently price assets more effectively than the market mechanism. The second reason flows from the first: The significant costs associated with asset value analysis and the active management of an investment portfolio (management fees, transaction costs, etc.) make it even harder for an individual to outperform the returns obtained by passively accepting market prices.

Contrary to popular belief, the fatal flaw with this paradigm is not that it assumes that markets are relatively efficient. If anything, this assumption constitutes a great advantage of this investment strategy, which is designed for the masses. For it would be quite absurd indeed to assume that the average individual will consistently be able to price assets more effectively than the market mechanism. And it is a mathematical impossibility for the majority of people to outperform the overall market. Thus, a modest regard for the analytical capacity of the masses should be seen as a great strength of the passive investing paradigm

The problem with the passive investment strategy derives from an entirely different aspect of human nature that is distinct from analytical capacity: emotions.

Constant exposure to markets means that passive investors will be subjected to intermittent episodes of hair-raising volatility. And the fact of the matter is that very few have the sort of emotional makeup that would allow them to sustain such a strategy over time.

The herding instinct is powerful. Very few individuals are emotionally equipped to stay the course and hold their positions -- much less buy -- when everyone around them is selling in a panic. For this reason, in practice, investors who putatively follow a passive investment strategy will in practice tend to get whipsawed. They will tend to sell toward the bottom, when stocks are cheap. And they will only buy once they are again comfortable and stocks are relatively expensive.

The strategy of passive investing may be theoretically sound on its own terms. However, in practice, it tends to fail because most people are emotionally unable to sustain it.

By definition, an investment strategy that is designed for the masses, but which does not account for how the masses tend to behave, is destined to fail. Such is the case with passive indexing or quasi-indexing strategies.

Overactive Strategies and Human Frailty

It may seem ironic given the above discussion, but another major reason why investors fail is that they're overactive. Unlike passive investors, active investors tend to believe that beating the overall market return is not overly difficult. Active investors tend to believe markets are "inefficient" and that market prices do not reflect their "true" or "intrinsic" values. These investors believe they can systematically exploit these inefficiencies for profit.

There are two reasons why active investors tend to fail.

Fatal Conceit

The first reason is that active investors tend to underestimate the relative efficiency of markets (relative to their own ability to price assets) and they tend to grossly overestimate their own abilities to identify and exploit supposed inefficiencies. Friedrich Hayek famously described the belief that an analyst can determine a "true" price that is more sound or efficient than that which is attained through the market process as a "fatal conceit." Although Hayek made this observation in the context of analyzing the possibility of socialist calculation, it applies to market investing just as well.

Stock market prices contain information in volumes that the analyst will never be able to fully capture, flowing from places where an individual analyst will never be able to go, and processed by minds the analyst will never be able to comprehend. It is quite a conceit for an analyst to think that, with what limited information they have and their limited processing power, he or she can price an asset more efficiently than the "invisible hand" that guides the market process.

It is unreasonable to expect that any individual analyst can, over time, generally price assets more efficiently than the market. Just as it is unreasonable to expect that central economic planners could set the prices of production inputs such as land, labor, or capital more efficiently than the market mechanism.

Indeed, it could be conceded that the market prices assets inefficiently to some degree most of the time. And we might even be able to concede that someone, somewhere is always exploiting those inefficiencies. But what seems to be abundantly clear with respect to any given analyst over time is that they will quite rarely be informationally, analytically, or emotionally positioned to identify, and much less exploit, whatever market inefficiencies may exist. Even the most talented investment analysts will only rarely possess an asset pricing edge over the market mechanism.

Thus, just as an economic system based on the ability of economists to consistently and effectively set factor prices is likely to fail, so too is an investment strategy likely to fail that requires analysts to frequently and consistently set asset prices more effectively than the market mechanism.
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Position in US Treasuries, SPX, VXX
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