Just Say No to Active Investing: Part 1
Active investing is any form of investing where you try to earn profit by purchasing things at a low cost and selling them at a high cost. The term “active” stands in contrast to “passive” investing. Most active investors buy and sell individual assets at a rapid pace in reaction to new market data. Most passive investors buy shares in large index funds and check back in after 10-20 years.
I actively invest 0% of my portfolio. Why? Because it is much more difficult to make good returns from active investing than most people recognize. And in the process of trying to make those returns, you must risk substantial portions of your principal.
I think that active investing continues to be so common because of ignorance. We don’t teach basic statistics and logical thinking in schools. If we did, I think the number of people who choose to actively invest their money would be much lower. I don’t think it would disappear. There are still ways to beat the market that I’ll get into later in this series, but the number of people who think that they can predict the price movement of Tesla stock would diminish sharply. In a world of unlimited resources, I would try to change the public education system. That’s way outside of my control, but I may be able to change individual minds.
How to Navigate this Post Series
This is a deep topic. I’ve broken it up into a couple of sections to explain key concepts. I’ve tried to write each section as a stand-alone piece so that you don’t need to read the entire thing from start to finish. As my own mother said when reviewing another one of my Overthinking Money blog posts “too damn long, honey.” So pick and choose the parts that are most interesting to you. I’ll update this header with links to each part as they are released.
A Very Short History of Investing in the US
Why Humans Are Really Bad at Active Investing
A Very Short History of Active Investing in the US
It takes a lot of time and energy to become an effective active investor. In this section, I try to prove that not many people have ever done that. Why is that important to my aversion to active investing? The small number of active investors throughout history suggests that most can’t make a profit doing it. If it was easy, lots of people would be rushing to do it.
What about all the financial influencers? My take is that it’s much easier to build and monetize a following than to become a successful stock trader. So with that, let’s do a very quick summary of the history of stock investing in the US.
Active Investing in the 1700s and 1800s
The very first stock exchange in the US only got started in the early 1790s. Sixteen years after the Declaration of Independence was published, the Buttonwood Agreement set out rules and principles that would make trading stocks easier. This organization eventually became the New York Stock Exchange [source]. This tree outside the NYSE today commemorates the original buttonwood tree that started it all:
During the 1800s, financial panics were frequent and disruptive. Major panics occurred in 1819, 1837, 1857, 1873, and 1893 [source]. Each of these events caused massive financial damage to businesses and households. But for all the damage they caused, the people that were directly invested in the stock markets and exchanges of the era were few and far between.
Active Investing in the 1900s
By 1929, only about 10% of people in the US owned stocks. Despite this, nearly 33% lost their life savings and jobs in the great depression [source].
Those that lived through the 1929 stock market meltdown mostly chose not to invest their money in stocks. It took until 1954 for the Dow Jones Industrial Average (DJIA) to reach 1929 levels again [source]. That’s a full quarter century. Not surprisingly, stock market participation by US citizens in the early 1950s was a scant 4.2% [source].
By 1982, financial markets had become considerably more efficient. The rise of exchanges and computerized buying and selling had changed stock trading from an elite activity to something accessible to most people. 28 years after the DJIA recovered from the 1929 panic, approximately 20% of Americans owned stocks [source].
Active Investing in the 2000s
Fast forward to 2023 and the number of people that report owning stocks has risen to 61% of Americans [source]. The growth of stock market ownership has accelerated rapidly, but the number of people who actively trade stocks remains quite low. Most of the households that own stock do so in the form of 401k plans and other passive instruments. This is borne out by data from the 1990s, early 2000s, and 2010s. During that time, there were probably only 10-20,000 active day traders in the US total [source]. Even including stock traders at banks and investment houses, the number is probably no more than ~2M [source]. Approximately 202M Americans own stock. That means that only about 1% of people who own stock in the US are actively trading.
That strongly implies that very few people have spent any substantial amount of time actively investing. And as with most skills, there is substantial evidence that more experienced investors earn more [source]. So it shouldn’t surprise you that most people who try to earn money by trading stocks either make very little or lose money [source]. And the “investors” who spend lots of time talking about it are almost certainly not making much profit.
Why Humans Are Really Bad at Active Investing
Human brains aren’t computers. Our memory is orders of magnitude less precise and our ability to perform arithmetic is extremely slow. I like to say that it’s more of a fluke that we’re able to think semi-rationally at all. We evolved to reproduce ourselves, not solve differential equations. The fact that only a couple members of our species have been able to do things like split atoms and invent neural nets is a testament to how bad we are at being objective and thinking rationally.
To facilitate our primary evolutionary goal of reproducing ourselves, our brains have developed all sorts of shortcuts and blindspots. These make us better at reproducing, but make us much worse at rational decision making. In this section, I’ll review 4 of the most important problems with our gray matter and how they limit our financial aspirations.
Survivorship bias is the tendency for people to confuse a visible and successful subgroup as the entirety of the larger group. The term “survivorship bias” actually comes with a neat little nugget of history.
During World War II, a famous statistician named Abraham Wald set out to determine how best to protect air force pilots. His group began by analyzing the parts of planes that were most damaged and reinforcing them. The underlying assumption was that those were the parts of the planes that most needed strengthening.
But Wald realized that the planes that most needed reinforcing weren’t returning to airfields at all. His group initially mistook the literal survivors of aerial combat for all air force planes. Through this realization, his group was able to analyze not just the planes that returned from sorties, but those that were downed in combat. His group’s suggestions led to hundreds of pilots surviving the war [source].
The insidious thing about survivorship bias is that it’s almost invisible. It’s an essential ingredient in most news reporting. After all, most of us wouldn’t read a headline titled “San Francisco Startup CEO Fails to Secure Seed Round,” even though that’s what happens to more than 99% of startup CEOs. By reading TechCrunch and Angellist, we confuse the visible winners in the startup funding game with all startup founders.
How Survivorship Bias Applies to Active Investing
There’s a reason that Warren Buffet gets so much attention. He’s that 1-in-a-billion investor that has been extremely lucky for an extremely long period of time. He shares this trait with most other moguls and captains of industry.
The story is the same for John D Rockefeller Sr.. He wasn’t originally in the oil business at all, but was instead a commodities trader. It was two of his associates that introduced him to Kerosene refining. If he hadn’t chosen those partners, he would never have learned about the oil fields in Pennsylvania. And when he ruthlessly cut his partners out of their business venture, he was fortunate that none of them were as cut-throat as he was. Then, there was the stroke of luck that crude oil was far more plentiful than people of his era assumed. On and on. You don’t get to become one of the world’s wealthiest humans without an insane amount of luck.
With active investing, you need to constantly remind yourself that you will only ever hear the stories of successful investors. After all, who would brag to other people about their financial failures? The closest you’ll get to that is the WallStreet Bets subreddit. It’s still mostly about the home runs, but there is the occasionally honest post about losing money.
Confirmation bias is the tendency to notice, emphasize, and give more credibility to evidence that fits our pre-existing beliefs.
The classic experiment that defined the term was conducted in 1960 by Peter Watson and you may have already taken the test. Here’s how it works:
Your goal is to figure out the rule that applies to 3 numbers. The numbers 2, 4, and 6 satisfy the rule. You can ask the experimenter to verify whether any set of three numbers adheres to the rule.
I’ve taken this test and my immediate assumption was that the rule was a series of consecutive even numbers. So a series of numbers like 10, 12, and 14 should fit the pattern. And lo and behold, they do! But if you bought into my assumption, you would be wrong.
The pattern that Watson had in mind was any series of ascending numbers. What he found in his research is that most participants form a belief and then seek to confirm it, rather than thinking of ways to dis-prove it [source].
That tendency to confirm a pre-existing belief rather than refute it is confirmation bias. And it’s practically a default mode of human thought. It’s not certain why we do this. My personal belief (watch out, dear reader, I’m seeking to confirm a theory!) is that it’s much cheaper for our brains to create a belief and reinforce it than to test competing theories. We only have so many hours in the day, after all.
How Confirmation Bias Applies to Active Investing
Let’s say that you have a hunch that Apple stock will go up after they ship their new VR headset. You start doing your research to figure out how high the price might go. Dozens of articles, blogs, and paid market reports later, you conclude that the stock could rise by as much as 15%. And it looks like nobody else is thinking like you! You’re gonna be golden. All you have to do now is buy as many shares as you can between now and then.
Did you spot the problem in the example above? You started from a belief that Apple stock was going to rise. And though it seems as though you did your research, all you did was seek out evidence that your hunch was correct. Instead of learning that you were wrong or just unsure, you convinced yourself that you could even predict the magnitude of the price jump.
This is a classic example of confirmation bias. Instead of trying to disprove yourself, you cherry-picked data that supported a pre-existing belief. People use confirmation bias to convince themselves of all sorts of hair-brained ideas. And even in the face of seemingly insurmountable evidence they are wrong, they double-down on the belief because it’s so unpleasant to admit you were wrong.
So the next time you think you’ve figured out something intuitive hidden in plain sight, try to seek out some contradictory evidence. If it’s easy to find, you’re probably living in a reality distortion field of your own invention. Be careful with confirmation bias, especially if there’s money involved.
The Dunning-Kruger effect occurs when a person overestimates their competence at a skill as a result of having moderate familiarity with it [source]. It’s the effect behind the phrase “knowing just enough to be dangerous.” Like so many other forms of hubris, there’s a whole subreddit devoted to this phenomenon: /r/confidentlyincorrect.
The problem is, the Dunning-Kruger effect is pretty much universal. At one point or another, we’ve all allowed our middling understanding of something to make us overconfident. Ordinarily, this is just irritating to those around us. But in matters of personal finance, this is a very serious cognitive bias that can lead to huge losses.
How Dunning-Kruger Applies to Active Investing
Let’s say that you go to a 4th of July picnic with some coworkers. Over hamburgers, Ted from accounting mentions that he’s been making a killing this year shorting stocks in the transportation sector. He’s already up $50,000 this year and he’s got a couple of big bets right now that could triple that return.
You’ve been trading stocks using Robinhood for a year or two and you’ve never been willing to risk more than a couple hundred dollars, but it’s been something you’ve enjoyed. You even read the Wall Street journal’s financial section sometimes. Short positions are something you’ve heard of, but never used. Robinhood makes it easy to leverage a short position to increase your upside, so that could be worth exploring. Shorting transportation sector stocks in particular isn’t something you’d thought about, but you’ve got all the tools to give it a try.
In this example, alarm bells should be blaring inside your head. You aren’t a stock trading newbie, but you are far from experienced. In short, you’re probably just knowledgeable enough to be a danger to your net worth. You are a walking, talking example of the Dunning-Kruger effect. Let’s just hope that you have someone close to you willing to be blunt about your ability to manage a short position before you get in over your head.
Here’s a fun fact for you: most people experience the pain of loss twice as acutely as the pleasure of gains. Put another way, you’re quite likely to be willing to spend $2 to avoid losing $1. This isn’t just some anecdote either, it’s a well-tested behavior that applies to most people and it’s called loss aversion [source].
When you come to think of it, loss aversion makes a lot of sense. Because the future is uncertain, the loss of an asset we currently possess hurts more than just the face value of that asset. Will we be able to get it back? When would that be possible? Who knows! The world is a cold, harsh place and the reality is you may never be made whole.
How Loss Aversion Applies to Active Investing
While this preference to avoid loss may seem emotionally intuitive, it undermines our ability to be effective investors. Experienced investors know for a fact that losses are inevitable. You cannot be right 100% of the time. To be effective, you must be able to emotionally handle the loss of some of your assets to earn outsize returns.
But our innate desire to avoid losing the things will push us to do ineffective things with our money. You may have the desire to sell a stock when its price declines, or purchase less volatile (and therefore less profitable) assets to avoid loss. In extreme cases, I’ve known people who are so loss averse that they refuse to invest their money at all. They prefer instead to keep vast sums of cash in savings accounts rather than lose a single cent to the fluctuations of the market.
Unless you are able to identify and combat your innate desire to avoid loss, your ability to shrewdly invest and reap rewards will be hampered.
Putting it Together: Cognitive Biases
I’ve just covered 6 of the well-documented cognitive biases that I have experienced myself. But there are loads more. If you’re interested in learning about more, this list is a good place to start.
Of course the really scary part of cognitive biases is that they all work together in real time. In many ways, we as humans are just thousands of biases and simple heuristics layered on top of each other. Our thoughts and decisions are more bias than logic. That makes it hard if not impossible to think rationally, most of all about financial decisions.
Follow along for part 2 in which I explain why no investing approach can possibly ever beat indexing and why most personal finance advice is in fact just stock picking.
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