People are cognitively very, very bad at taking all costs into account when calculating investment returns. In one haunting example from a New York Times article on real estate, one investor illustrates this perfectly:
By comparison, he views the four-bedroom home he bought for $32,500 in 1965 – or about $200,000 in today’s dollars – as a money tree. He and his wife recently listed it for $413,000. That would translate into an annual return of 1.2 percent, taking into account inflation and the cost of two new decks and an extra room.
They plan to move to Texas after it has sold. “I wish I’d bought more real estate,” Mr. Larson said.
Regular readers of iwillteachyoutoberich will know that you could earn several times the 1.2% return simply by investing in a simple target-date fund or index fund. We’re not properly wired to calculate all costs of our purchases; in this case, taxes, and all the other costs of buying a house.
Sadly, Mr. Larson truly believes that he got a great return.
When I recently asked “What are areas where people THINK they earn a lot, but actually don’t?” iwillteachyoutoberich reader Baron wrote a fascinating comment about a group I hadn’t heard of before.
“individual stocks. ever heard of the beardstown ladies? they thought they were performing as well as warren buffet. when the accountants went through their numbers, they actually underperformed the market. people screw up accounting all the time whether it’s stocks, real estate, or some other investment.”
This was news to me, so I dug around. From Wikipedia:
The Beardstown Ladies were a group of older women who formed an investment club, formally known as the Beardstown Business and Professional Women’s Investment Club, in Beardstown, Illinois, USA.
In 1998, an article in Chicago magazine asserted that the group’s stated returns had included the new investments made by its members, and that when computed in conventional fashion, their annual rate of return for 1984–1993 was actually 9.1%, considerably less than the 14.9% return on the S&P 500 during the same period. Outside auditor Price Waterhouse, hired by the club, confirmed the sub-par 9.1% annual rate for 1984–1993. The auditor also discovered the Beardstown Ladies’ annualized return was 15.3% when all of 1983–1997 was included; this was better than the average stock fund at the time, but still worse than the S&P 500 return of 17.2% for the same period.
- “Investing” does not mean picking individual stocks. Few people can pick stocks and beat the market. Nearly no one can do this with regularity. Instead, as a general rule, invest in low-cost target-date funds.
- Let’s break this down by smart, ordinary, and dumb people: Very dumb people don’t read this blog, so they don’t even think about this and we don’t need to waste more time on them as a category. Moderately intelligent people also generally ignore personal-finance advice, or they may eventually listen. Whatever. Let’s talk about smart people. Smart people generally believe and adhere to the evidence that you can’t beat the market. But here’s the twist: Ironically, HIGHLY INTELLIGENT people believe they can out-smart this advice — and the equally smart people on Wall Street, who also fail to beat the market — and invest in individual stocks anyway. They pay the price — though they may never realize it.
In my book, I do an exhaustive review of so-called experts and show you sophisticated tricks that Wall Street uses to trick you into believing they perform better than they actually do.
Read several book excerpts here.