When the stock market dropped in the early months of 2018, including a 1,175 point plunge in the Dow Jones Industrial Average on February 5, many individual investors asked, “Is it time to sell?”
There’s an understandable logic to selling at the first sign of trouble, to getting out before things get worse, but as the history of markets shows, that reaction is dead wrong. One of the most basic errors that investors make is to extrapolate from the recent past while underestimating the randomness of financial returns.
Fortunately, there are proven strategies for avoiding this error. The two keys to long-term investing success are to diversify investments and minimize fees. These principles aren’t secret, but too many people still fail to use them.
How might individual investors follow these better strategies? Two common recommendations are to hire a financial adviser or improve financial literacy. But, counterintuitively, many financial advisers simply compound their clients’ mistakes. And a recent meta-analysis of over 200 financial-literacy interventions found that, on average, literacy interventions did not improve investors’ behavior.
Given the time periods over which most individual investors receive and process stock market information, stock market changes may as well be purely random.
Behavioral science suggests a better way to guide people toward wise investing. In new research, Katie Parker and I find that many investors can be helped via the simple psychology of “nudging.” The answer involves digging deeper into investor psychology than the current boiler-plate advice, “Past performance does not guarantee future performance.”
There are compelling reasons to not try and play the market. The first is our limited capacity to predict the future. Humans are hardwired to draw associations, infer meaning, and find patterns so that we can make predictions about the world. Although this pattern detection works exceptionally well in relatively simple systems, it can by hoodwinked by more complex data, and observers can end up being “fooled by randomness.” Stock markets are vastly complex systems that humans aren’t evolved to predict. Given the time periods over which most individual investors receive and process stock market information, stock market changes may as well be purely random.
There’s a second reason not to try and predict the market: it’s expensive. Frequent transactions incur taxes, charges for someone to manage the money, or a fee to transact. This leads to a timeless piece of investment wisdom: don’t try to predict the market—just minimize the fees you pay. Although the underlying information is random, investors’ mistakes certainly are not. We mistakenly extrapolate recent performance into the future. If we were perfectly rational calculating machines, then the accurate advice, “Past performance does not guarantee future performance,” should help correct that mistake. That many individual investors ignore this advice is but one piece of evidence that we are not perfectly rational.
Counterintuitively, many financial advisers simply compound their clients’ mistakes. And a recent meta-analysis of over 200 financial-literacy interventions found that, on average, literacy interventions did not improve investors’ behavior.
Although human behavior makes it challenging to invest strategically, it also suggests opportunities to do it right. One such opportunity is that we are social creatures. We are more likely to tidy up, pay our taxes on time, or make greener energy choices when reminded that others act in these ways. Wealth’s effect on happiness is driven by our wealth relative to others around us rather than directly following from the number of zeros on our investment account balance.
In our new research, Parker and I tried to leverage the power of social comparison in a new piece of single-sentence investment advice. Our approach was twofold: first, to acknowledge the allure of past performance, but then to also tell investors (truthfully) that minimizing fees is the best way to grow wealth compared to others. We thought that increasing the salience of relative performance would make fees more salient by piggybacking on our attentiveness to social comparison.
Real-world financial decisions are incredibly complex. Researchers often try to isolate variables by getting experimental participants to make hypothetical investment decisions (but with real financial consequences). In our research, conducted in the U.S., we asked participants to choose between four stock mutual funds. Following previous research, we arranged funds so that the fund that had historically performed best also had the highest fees. Although in reality this fund would be a statistical anomaly (stock funds with the lowest fees have the highest average returns), it allowed us to separate the strategies of maximizing past performance and minimizing fees. A one-sentence piece of investment advice was placed immediately above where participants clicked their final choice.
Given the time periods over which most individual investors receive and process stock market information, stock market changes may as well be purely random.
We found that advice based on social comparison, “Some people invest based on past performance, but funds with low fees have the highest future results,” performed far better across three experiments than a piece of factually-equivalent but non-social advice, “Past performance does not guarantee future performance.” We also found that the social comparison advice worked better even than the following disclaimer, which previous research suggested as an improvement on the current real-world advice: “The most important single factor in mutual fund performance is the fund’s fees.” Small changes in how investment advice is worded can substantially improve behavior—another demonstration of the power of nudge.
Some readers might (rightfully) worry about whether these results will generalize to real-world decisions. But we found that more financially literate participants actually preferred the incorrect high-past-performance fund. And while in none of our experimental conditions did all participants manage to make the best choice, this is one piece of evidence that many investors can be helped by advice which gets closer to the heart of investor psychology and motivation.
So ignore what others around you are doing, and follow the proven advice to get ahead by paying the financial industry as little as possible.
