| Rational
Investing in Irrational Times: How to Avoid the Costly Mistakes
Even Smart People Make Today
By
Larry E. Swedroe
Published
by Truman Talley Books, 2002; ISBN: 0312291302
352 pages; $24.95
Reviewed
by Catherine M. Censullo
MARCH
2006 - Swedroe’s previous books are The Only Guide
to a Winning Investment Strategy You’ll Ever Need and
What Wall Street Doesn’t Want You to Know. His
purpose in this, his latest effort, is to help investors greatly
improve the likelihood of achieving their financial objectives.
The
book uses a question-and-answer format to identify the many
mistakes that even the smartest investors make, regardless
of market conditions. The author accomplishes this by sharing
with his readers mistakes he has witnessed, then explaining
why they were mistakes, why investors made them, and how
to avoid them. Swedroe describes 52 common mistakes and
breaks them down into four categories.
The
first category covers how understanding and controlling
human behavior is an important determinant of investment
performance. Even though individual investors as a whole
underperform the appropriate benchmarks, people are confident
that they themselves can successfully outperform them.
Common
mistakes that investors make in this category include allowing
their individual egos to dominate their behavior by inflating
the investor’s confidence, trusting their intuition
regarding investment decisions, and confusing luck with
skill. A study conducted by an independent financial services
research firm on the performance of individual investors
for the 15-year period ending in 1998 demonstrated just
how expensive overconfidence can be. It found that the individual
investor buying and selling individual stocks and no-load
mutual funds earned an average annual return of 7%. During
the same period, the S&P 500’s average annual
return was nearly 18%. The individuals’ cumulative
return for the period was 140% versus a cumulative return
of the S&P 500 of 820%.
The
second section explains how ignorance is bliss: how people
confuse information with knowledge and rely on misleading
information. For example, many individuals mistakenly believe
that investing in the Morningstar top performers will deliver
top performance, and that active managers will protect them
from bear markets. Another popular misconception is that
hedge-fund managers deliver superior performance.
Regarding
the Morningstar misconception, Mark Hulbert’s The
Hulbert Financial Digest tracked the performance of
the five-star funds for the period 1993 to 2000. For that
eight-year period, the total pretax return on Morningstar’s
top-rated U.S. funds averaged 106%. This compared to a total
return of 222% for the total stock market, as measured by
the Wilshire 5000 Equity Index. To make matters worse, the
top-rated funds carried a relative risk that was 26% greater
than that of the market.
The
third section focuses on mistakes made when planning an
investment strategy. Confusing speculating with investing,
trying to time the market, and relying on market gurus are
among the mistakes that many investors make. Also, people
often fail to understand the importance of saving early
in life.
A study
conducted by John D. Stowe called “A Market Timing
Myth” looked at the impact of eliminating the best
and worst 10, 20, 30, and 40 days of market performance
during the period. Stowe’s study showed that the odds
of winning a state lottery are far better than the odds
of being able to avoid the worst 10, 20, 30, or 40 days
during a given period. This and many other studies have
shown that market timers do not beat the market.
The
fourth section deals with mistakes made when developing
a portfolio. These mistakes include having too many eggs
in one basket, underestimating the number of stocks needed
to build a diversified portfolio, mistaking diversification
with the number of securities held in the portfolio, and
chasing the initial public offerings (IPO) dream. Investors
who mistakenly believe that portfolio diversification is
measured by the number of stocks they own do not understand
the importance of the asset classes that make up a portfolio
and how important the correct construction of those asset
classes is to the performance of the overall portfolio.
Swedroe
is a proponent of the principles of modern portfolio theory
and the efficient market theory. He shows that trying to
outperform the market is futile for even the most accomplished
experts. This book is an entertaining and informative guide
that supports the development of a globally diversified
portfolio consisting of multiple asset classes through the
use of passively managed asset-class mutual funds, broad-based
index funds, or their equivalent exchange-traded funds.
It is a must-read for investors who think that they can
outperform the market or that they can choose and follow
a market guru who is capable of doing so.
Catherine
M. Censullo, CPA, PFS, a sole practitioner based
in North White Plains, N.Y., is a member of the NYSSCPA’s
Personal Financial Planning Committee. |