“Most of what we call ‘human nature’ becomes a deadly quicksand of maladaptive behavior when allowed to roam free in the investment arena.” –William Bernstein
Harvard psychology professor Dan Gilbert jokes in his book, Stumbling on Happiness, that all psychologists vow, sometime in their career, to finish the sentence “The human being is the only animal that…” Gilbert then states, “I have never written The Sentence, but I would like to do so now, with you as my witness. The human being is the only animal that thinks about the future.” Philosopher Daniel Dennett expressed a similar idea when he called the human brain an “anticipation machine” and noted that “making future” is the most important thing it does.
This unique ability to contemplate the future has served us well. It allowed us to progress from hunter-gatherers to farmers. It allowed us to develop tools to make our lives easier. It brought us the renaissance, scientific thought, and the industrial revolution. It lead to the invention of the wheel, the printing press, the internal combustion engine, and the internet. It allowed us to create profound works of literature and art of unspeakable beauty. It brought us the information age and technological wonders that would appear magical to people 100 years ago.
Unlike many others I am optimistic about the future. And the cause for my optimism is that we as humans can think about the future, and in many senses, as Dennett said, “Make it.” This ability has served us well in the past and I believe there is ample evidence that it will lead to an even brighter future.
Entwined with our unique ability to think about, anticipate, and plan for the future is that we also have a powerful desire to predict it. This, too, can be useful at times but it can also get us into trouble. Indeed, evidence shows that this need to predict the future is part of our human nature that William Bernstein described as “a deadly quicksand of maladaptive behavior” when we use it to make investment decisions.
Humans vs. Pigeons
The potential pitfalls of our need to predict the future were demonstrated by a series of interesting experiments matching humans and pigeons in contests to predict which of two lights would flash. As described by Jason Zweig, in his book Your Money and Your Brain, in these experiments either a green light or a red light was flashed. The goal of both birds and humans was to predict which color of light would flash next. Correct predictions were rewarded.
Over each set of 20 flashes the green light was programmed to flash 80% of the time and the red light 20% of the time. Other than this ratio the flashes were completely random. There was no pattern.
The pigeons quickly figured out that the green light flashed much more often than the red light. They were also quick to admit their limitations. Their thought process, if they were capable of thought, would have been something like this: “The green light flashes more than the red light, and I get a reward if I correctly predict which light will flash. However, I am just a pigeon, with a bird-sized brain, and I am not nearly smart enough to predict the future. So to maximize my rewards I will just predict the green light will flash every time.” While the pigeons might not think like this, they do behave accordingly, and by consistently predicting green flashes they are right nearly 80% of the time.
Humans also figure out quickly that the green light flashes much more often than the red one. However, we lack the humility of the pigeons. We “know” there must be a pattern to the flashes and we believe we are smart enough to figure it out. Our need to forecast the future takes over and we try to predict when the rare red flashes will occur. The result of our overconfidence is that humans only predict the flashes correctly 68% of the time.
Even more amazing, humans continue to predict when the red lights will flash even when we are told the flashes are random. Our need to predict the future, and our confidence that we can do so, are so strong we keep trying in spite of evidence that it is not possible and that our efforts are harmful. In this contest between humans and pigeons the birds were a clear upset winner.
Humans, Pigeons, and Investing
It strikes me how similar the flashing light experiment is to investing in the stock market. Over time it is clear to anyone paying attention that the market is up more often than it is down. This is true if you look at days, months, years, or decades. While the market is not up 80% of the time the pattern that it rises more often than it falls is evident.
It is also apparent that it is impossible to predict what the market will do next. No one knows where the market is heading tomorrow, next week, or next year. Legendary investor Warren Buffett admits, “I never have the faintest idea what the stock market is going to do in the next six months, or the next year, or the next two.” As author Jane Bryant Quinn quips, “The market timer’s Hall of Fame is an empty room.”
As you might expect, given the human need to predict the future, these facts have not stopped us from trying to forecast the market. And as you might also expect the results have not been good. Indeed, famed investor Peter Lynch remarked, “Far more money has been lost by investors in preparing for corrections, or anticipating corrections, than has been lost in the corrections themselves.”
How badly has the human need to predict the future harmed investors? A DALBAR study of the 20-year period ending in 2009 provides a clue. The study compared the performance of the S&P 500 Index with the investment results achieved by individual investors in stock mutual funds.
The S&P 500 Index is made up of 500 of the largest US based companies and is often used as a proxy of market performance. The S&P 500 Index reflects the performance of the companies in the index. Individuals can achieve the results of the index, less a small management fee, by simply buying and holding an S&P 500 Index Fund. In other words, the S&P 500 plays the role of the pigeon, always predicting “green”.
Individual investors, on the other hand, persist in trying to predict the future. They are constantly trying to forecast when the next “red” light will flash, and they move their money in and out of the market based on their predictions. In the period from 1990 through 2009 the DALBAR study found the S&P 500 Index averaged 8.2% annual returns while individual investors in stock mutual funds averaged only 3.2%. People sacrificed, through poor investment decisions, over half of the returns they could easily have achieved through an index fund. This 5% difference, known as the “behavior gap”, is caused largely by people trying to predict the future by timing the market.
To make matters worse, each market-timing move involves at least two decisions; When to get out and when to get back in. And you need to time both of them almost perfectly for it to be worthwhile. This is because market gains and losses are usually concentrated in just a few days of the year.
Walt Bettinger reported that in 2014 the S&P 500 delivered a gain of 13.7%. Missing out on the top 10 days that year would have turned that 13.7% gain into a 3.1% loss. Nobel Prize winner William Sharpe calculated that a market-timer must be right 82% of the time to match a buy-and-hold return. That is a rate of success no one can maintain over time, and an awful lot of work for something you can achieve by simply purchasing an index fund and doing nothing.
The conclusion is obvious. If pigeons knew about index funds they might very well be better investors than most humans. And the lesson for us is just as clear. Learn from the pigeons and always predict green. Simply buy and hold an index fund. As Charles Schwab wrote, “When it comes to investing, slogans are no substitute for strategy. But if there’s one investing adage that comes close to a rock solid principle, it’s this. Time in the market is more important than timing the market.”
I am not asking you to give up your unique human advantage. By all means continue thinking about the future, anticipating the future, planning for the future, setting goals for the future, and working hard to make tomorrow better than today. However, at least when it comes to investing, you will be much better off if you stop trying to predict the future.