How to grab fools' money
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“A fool and his money are soon parted,” goes the old saying. What has always puzzled us is how the two of them got together in the first place. But we know what happens next: he invests carefully and spends wisely – until it is all gone.
Once the fool gets his hands on some real dough, a whole industry of clever people gets to work to try to take it away from him. They offer to protect it, to manage it, to invest it, coddle it, caress it, clip its nails and dye its hair. And when they’re finished, there is often nothing left.
A young friend of ours just announced that he is setting up his own shop – to manage other people’s money. Why money management? Because it’s a way for him to make a lot for himself. Our young friend knows nothing about investing – or not much. How can we be sure? Because we taught him everything he knows. Yet he is now providing financial services to wealthy clients – one of thousands, maybe millions, of people in the world’s most profitable sector. His model portfolio is already up 38% so far this year, he says. But most likely, he will do no better and no worse than other investment professionals. He may not understand the Black-Scholes option-pricing model, but
he has already mastered the essential calculation of the financial industry: his performance will be mediocre, but his remuneration will be outstanding.
It is probably a mistake to give our friend any money to manage. But investors make a lot of mistakes, says the FT. “Humans are
hard-wired to be irrational when it comes to financial decisions,” observes Whitney Tilson, adding earnestly that “we must understand that, so we don’t become the sucker at the poker table”. The article goes on to explain all the irrational ‘mistakes’ investors make, as ferreted out by academic researchers in a field known as ‘behavioural finance’.
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“They trade too frequently, the stocks they sell do better than the ones they bought, and they don’t diversify,” say the professors. “People also suffer from the confirmation bias. They decide whether they like a stock and then look for evidence that confirms that view.” Every study shows that investors follow the crowd. They say: “‘All these [other] people must know what they’re doing.’ People pile into whatever the hottest fund is and get massacred.”
Recognising their own weaknesses, many investors are tempted to let the experts manage their money. But are the professionals not human too and not subject to the same impulses, delusions, and errors? Most likely, they are even more prone to mistakes, since they follow more closely the opinions and fashions of the trade. Besides, it’s not even their own money they are playing with; it’s their clients’ money.
Tilson concludes: “My opinion is that 80% of money managers are not suited to be professional… The bulk of the money in this world is managed in a cover-your-ass fashion.” The private investor has a choice. He can make his own mistakes. Or he can let the financial industry make mistakes for him… and pay dearly for the privilege.
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