Old Upset

Save Yourself the Headache…And The Hole in Your Wallet!

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Old Upset
"Experience is simply the name we give our mistakes." - Oscar Wilde

As children, my brother and I were into riding BMX bikes during the customary age where "being cool" took precedence over "being smart." My mother would always tell us to make sure we wore our helmets, knee pads, and elbow pads for caution. She probably would have smothered us in bubble wrap if she had the chance. Unfortunately, these words would usually fall upon deaf ears, as my brother and I were always overconfident in our ability to escape the thrashing that came from falling – often coming home with more scrapes and bruises then we could count. After losing enough skin and being constantly overwhelmed with the pain that accompanied every slight movement we made, my brother and I eventually learned the idea of being "smart" – although I would argue (and many could vouch for me) that I have not completely mastered the concept.

Experience is often the greatest motivator for changing our behavior. Whether it be falling down enough times while riding BMX bikes or losing enough money to squash the illusion that the odds are in your favor when you decide to visit Las Vegas, we often need to learn the hard way. As the Oscar Wilde quote referenced above astutely points out, "learning from experience" is just another way of saying "learning from our mistakes." And beyond remedial scrapes and bruises, certain mistakes can be very expensive – like investing mistakes. 

Frequent trading, by far, is one of the biggest mistakes many investors make – mainly due to overconfidence about their knowledge or skill set in a highly competitive market place. I recently wrote an article detailing the impact that trading costs have on performance as it applies to large mutual fund companies. The same principles readily apply to individual investors. Terrance Odean and Brad Barber estimated the underperformance between those who trade frequently and the market was 6.50% per year from 1991 – 1996.1,2 In practical terms, this performance difference would amount to $387,317 in total return for a $500,000 portfolio originally invested in 19913. As far as reasoning goes, the authors claim, "we believe that these high levels of trading can be at least partly explained by a simple behavioral bias: People are overconfident, and overconfidence leads to too much trading."

Overconfidence is often a description that accurately classifies those who are relatively younger. When I was 18 years old, I thought I had the entire world figured out. But time has a way of humbling even the most certain of us, and investing is no more immune to it than anything else.

In a recent paper entitled "Getting Better: Learning to Invest in an Emerging Stock Market"4, researchers identified a positive relationship between performance and experience – mainly age. Observing over 11.6 million individual accounts from India's National Securities Depository Limited (NSDL), professors John Y Campbell, Tarun Ramadorai, and Benjamin Ranish concluded that more "experienced" investors remain committed to prudent investing practices such as infrequent trading, staying diversified, and staying clear of the popular "disposition effect" – accelerating the realization of capital gains and deferring the realization of offsetting losses.

Now there are some experiences that we cannot escape. Knowing what it feels like to get your heart broken, learning that life is expensive, and dealing with the ever increasing grey hair are all things that are inescapable. Experiences like these make knowledge akin to fine wine – it ripens with age.

But adopting a prudent investment strategy doesn't have to come at the cost of learning how to lose money.  

Jim Parker of Dimensional Fund Advisors recently wrote, "there are two ways of learning: you can be taught how to do something correctly, or you can be shown the consequences of doing it wrong. In the world of investing, it's a lot cheaper to learn from others' mistakes."5

I agree!

1 Barber, Brad M. & Terrance Odean. "Trading Is Hazardous to Your Wealth: The Common Stock Investment Performance of Individual Investors." The Journal of Finance: Vol. LV, No. 2, April 2000.

2 This performance figure is adjusted for the Fama-French risk factors.

3 This is assuming the market rate of return cited in the paper of 17.9% for the value-weighted CRSP Index and 11.4% for those who traded the most in the research paper.

4 Campbell, John Y., Tarun Ramadorai & Benjamin Ranish. "Getting Better: Learning to Invest in an Emerging Market." Harvard University & Oxford University: March 2013.

5 Parker, Jim. "Expensive Mistakes." Dimensional Fund Advisors, March 2013.