Why do most people invest incorrectly?
People Are Overconfident
Many of the best research in the world has strongly indicated that people, in general, are overconfident. For example, when students are asked in a classroom “Are you a more skillful driver than your average classmate?” the vast majority say that they are better than average. When individuals are asked about their athletic ability almost everyone is also above-average. The same goes for investing, most people think they know how to invest, especially in periods of market booms when most assets are giving significant profits. Statistical studies have shown that investors tend to interpret investment success as a confirmation of their investment skills, even if their positive financial return was due to luck rather than skill (Statman et al. 2006). Investors often have problems differentiating good fortune with investment skills (Malkiel and Ellis, 2013).
Individuals think they know more than they do, on average. People often like to express opinions on subjects they know little about, many times leading to incorrect acts on these opinions. We all know people, be it at work or in your family, who know nothing about a specific matter but always want to leave their opinion and are sure that they are right. According to research, on average, individuals who are certain about something are right 80% of the time (Fischhof et al., 1977). In investment, much of the same happens. Many individuals who had no training in finance or investments and never worked with anything related are often confident that they know what the best investment is. This overconfidence phenomenon can interact with the other issues already explained when their parents, friends, and social circle think about the same on investments, making it harder for the individual to accept that they are wrong.
Another feature of overconfidence already shown by top-notch research is that in situations involving uncertainty individuals try to look for past patterns of similar situations to predict the future without looking enough for the reasons why such pattern should continue. In academia, this is called representativeness heuristic (e.g. Tversky and Kahneman, 1974). In investments, representativeness heuristic can be easily observed. For example, when choosing which fund or stock to invest (Barberis et al., 1998), individuals often look for their past performance as satisfactory past returns would increase the odds of future satisfactory financial returns. However, stock markets are a random walk and stock prices reflect all available information. You cannot predict future returns by looking at past results (Malkiel, 1973). That is why, historically, when trying to figure out if the market will go up or down, investors are 50% of the time wrong and 50% right (Malkiel and Ellis, 2013). In 1999, Nobel Laureate Robert Shiller asked investors:
"If the Dow [Jones Index, which measures the stock of 30 major US companies] dropped 3% tomorrow, I would guess that the day after tomorrow the Dow would:
3. Stay the same
4. No opinion"
According to the results, 56% said that the Dow Jones would increase, 19% said to decrease, 12% stay the same, and 13% no opinion. Thus, although most institutional investors know the Efficient Market Hypothesis and consequently the idea that it is impossible to predict the stock prices in the short term (Fama, 1970), the vast majority of the surveyed investors said that they had an idea of where the market was going the day after.
Under complete information, if investors were perfectly rational (i.e. their goal was only to maximize their wealth by investing in a way to maximize their returns and decrease their risks) they would allocate their resources in low-cost total market ETFs and index funds rather than cherry-picking the "best" stocks and funds (Shiller, 2000). However, they usually still prefer to try to outperform the market, often leading to lower returns and higher risks.
- Barberis, Nicholas and Andrei Shleifer, and Robert Vishny (1998), “A Model of Investor Sentiment,” Journal of Financial Economics, 49: 307–43.
- Fama, Eugene (1970). "Efficient Capital Markets: A Review of Theory and Empirical Work," Journal of Finance, American Finance Association, vol. 25(2), pages 383-417, May.
- Fischhof, Baruch, Paul Slovic, and Sarah Lichtenstein (1977), “Knowing with Uncertainty: The Appropriateness of Extreme Confidence,” Journal of Experimental Psychology: Human Perception and Performance, 3 : 522–64.
- Malkiel, Burton Gordon (1973). A Random Walk down Wall Street: The Time-Tested Strategy for Successful Investing. New York: W.W. Norton.
- Malkiel, Burton Gordon., and Charles D. Ellis (2013). The Elements of Investing: Easy Lessons for Every Investor. Hoboken, NJ: John Wiley & Son Inc.
- Shiller, Robert (2000). Irrational Exuberance. Princeton, N.J. :Princeton University Press.
- Statman, Meir, Steven Thorley and Keith Vorkinki (2006). “Investor Overconfidence and Trading Volume.” Review of Financial Studies, 19:4, 1531-1565.
- Tversky, Amos & Kahneman, Daniel (1974). Judgment under uncertainty: Heuristics and biases. Science, 185(4157), 1124–1131
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.