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

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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.

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 



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