Why do most people invest incorrectly?
People Are Influenced by Society (Herd Behavior)
Comprehensive research has repeatedly shown that real estate gives much lower financial returns than a simple total market ETF or index fund and the allocation of part of your investment abroad can decrease your risks and increase your returns. However, when considering investments, individuals are highly influenced by the society, especially authority figures (like parents) to invest in a specific asset (e.g. real estate) or to not invest in others (e.g. international stocks).
One basic observation of human society is that individuals who communicate with each other frequently tend to think alike (e.g. Shiller, 2000; Thaler and Sunstein, 2008). A famous experiment selected hundreds of individuals randomly and gave them a list of questions with obvious answers (Asch, 1952). For example, in school, we learn that the USA is a country or a planet? Half of these randomly selected individuals were placed in groups of 7-9 people who were told by the researcher to say the correct answer to the list of questions (i.e. the control group). The other half of the randomly selected individuals were placed in groups of 7-9 people who were told to deliberately say obviously wrong answers for most of the questions, e.g. the USA is a planet (i.e. the treatment group). After hearing the answers from the other people in their groups, the randomly selected individuals were asked to give their answers to the obvious questions. The individuals placed in the groups in which the trained people were giving deliberately wrong answers (e.g. the USA is a planet) gave obviously incorrect answers 1/3 of the time. The individuals placed in groups in which the other people were trained to give correct answers (e.g. the USA is a country) were much less likely to say the wrong answers. Additionally, the subjects placed in the treatment groups showed multiple signs of stress and anxiety as they were afraid of being labeled as foolish or different by the colleagues if they gave a wrong answer. This experiment was later replicated 130 times in 17 countries and the overall result remained the same (Sunstein, 2003).
Initially, Asch (1952) experimental results were understood as a result of social pressure (Asch, 1952). However, later, this experiment was replicated without the use of pre-trained people. Instead, individuals were basically given "cold" numbers. For example, half of the randomly selected individuals were informed that 80% of people think the US is a planet. Additionally, in this latter experiment, the randomly selected individual could not be identified by their peers. The experiment was anonymous, which is significantly different from the previous experiment. In the previous experiment, individuals were placed in a group in which 80% of people were used to look at them, face to face, and say that the US is a planet. The result of the experiment with cold numbers and no face to face interaction was that the percentage of randomly selected individuals giving obviously wrong answers was almost the same as for the face to face experiment. Therefore, social pressure could not be the primary reason why people were given clearly wrong answers. The problem was conformity. People, in general, are unlikely to believe that the majority is wrong. If most of the people are saying so it should be right (Deustch and Gerard, 1955).
In finance, much of the same herd behavior happen with many investors. For example, many individuals who see most of their immediate contacts and social circle investing in real estate are highly suspicious when told that real estate is usually a very poor investment. However, on average, for every 100 thousand invested in real estate you lose 300 thousand in 30 years compared to a simple total market ETF.
Other investors observe that all their colleagues are looking for funds that can outperform the market. Consequently, you may show these individuals all the best data and financial models in the world demonstrating that a simple market index consistently beat professional managers trying to buy stocks or bonds when their prices are "low" and sell when they are "high," but they often will not believe in you.
The power of authority
Also related to herd behavior, individuals are also very influenced by "authorities", like parents or professors. In a classic study (Milgram, 1974), an "expert" experimenter asks multiple volunteers to "give" increasingly strong electric shocks to another person in a locked chair in a room next door. In fact, the volunteer is not administering any real electric shock but they think they are. The person (i.e. actor) "receiving" the shocks is unknown to the volunteer administering the electric shocks. The volunteer is told that the individual under research is the one receiving the electric shocks, not them, so their behavior does not change. After 75 volts, the actor in the other room is trained to start to grunt; complaint at 120 volts; ask to quit at 150 volts; later to beg to stop, and let out agonized screams at 285 volts. After, in complete desperation, the actor is told to yell loudly and talk about heart pain. Later, the actor would not answer any more questions possibly due to a heart attack or even death. If the shocks were real the highest electric levels (three 450 volts shocks) administered by the volunteers would have literally killed the person in the electric chair. The result of the experiment showed that an impressive 65% of the volunteers would have killed the patient. All volunteers administered shocks of at least 300 volts. This experiment is often cited as an example of the power of authority of individuals. If a simple "expert" can convince people to pretty much kill a colleague, it seems easy to see that parents can deeply influence individuals' investment choices.
In summary, society (in general) and authorities are many times right, but they are also often wrong and it is very hard for many people to go against them. Therefore, investment allocation is often influenced by figures of parents, friends, and other people who may never have studied or worked with investments, potentially leading to investment portfolios with lower returns and higher risks.
"I’ve always said if you’ve got an IQ of 160, give away 30 points to somebody else, because you don’t need it in investments. What you need is emotional stability. You have to be able to think independently, and when you come to a conclusion you have to really not care what other people say. Just follow the facts and your reasoning. That’s tough for a lot of people." - Warren Buffett, For Many The Greatest Investor of All Time
"The less attention you pay [to the news], the more money you will have." - Richard Thaler, The 2017 Nobel Winner
- Asch, Solomon. Social Psychology (1952). Englewood Cliffs, N.J.: Prentice Hall.
- Deutsch, Morton, and Harold B. Gerard (1955). “A Study of Normative and Informational Social Influences upon Individual Judgment.” Journal of Abnormal and Social Psychology, 51: 629–36.
- Milgram, Stanley (1974). Obedience to Authority. New York: Harper and Row.
- Shiller, Robert (2000). Irrational Exuberance. Princeton, N.J. :Princeton University Press.
- Sunstein, Cass (2003). Why Societies Need Dissent. Cambridge: Harvard University Press.
- Thaler, Richard H., and Sunstein, Cass R. (2008). Nudge: Improving Decisions About Health, Wealth, And Happiness. New Haven: Yale University Press.
- Wolff, Edward N (2017). “Household Wealth Trends in the United States, 1962 to 2016: Has Middle Class Wealth Recovered?” NBER Working Paper No. 24085.
IMPORTANT: THERE IS NO ONE BEST TAX OR INVESTMENT STRATEGY. IT ALL DEPENDS ON YOUR GOALS, RESOURCES, AND CITIZENSHIP.
For example, are you willing to move abroad? If so, where? How long do want to stay in each place? What is your annual income? How much money are you willing to invest? Do you want short term gains or long-term investments? What is (are) the source(s) of your income? How much taxes do you pay annually? Do you want to decrease your tax duties or completely remove them? Do you feel like you want to pay some taxes even if you do not need to? What is your citizenship? Do you have multiple citizenships? Depending on each of these answers the best investment/tax strategy for you will differ. In order to see what option is best for you and to help with the implementation of the strategy feel free to reach out to us. You do not need to be rich to create a global investment portfolio. Most of the bank and brokerage accounts we open do not have minimum initial deposit or maintenance fee. Thus, you can invest as much as you want or even leave the accounts empty until you have enough capital or interest to invest abroad.