Share punters can outpick professionals
Ever noticed how badly the experts tend to perform in share-tipping contests? Think of the newspaper competitions that pit stock-picking gurus against members of the public. The current leader of one Fairfax Media competition is astrologer Doreen Daze.
In the past, the "dartboard" selection or random picks has also been a strong performer.
Despite the highly paid professionals' expertise, it is not uncommon for them to lag towards the back of the pack.
When you consider that funds management costs Australians about $10 billion a year, this raises a thorny question for the massive superannuation industry. Can punters with little financial expertise consistently beat the professionals?
The growing army of people managing their own super suggests many think they can. But logic tells you they should not be able to. With all the hours spent studying the financial markets, and their sophisticated models, fund managers surely have an edge, right?
This question will only become more significant as the $1.5 trillion pool of super money continues to grow. And behavioural economics, which borrows from psychology, has uncovered some fascinating insights.
For all the sophisticated tools used by professional investors, studies have found that investments based on simple rules of thumb can outperform experts and the market average.
These are well explained in a book called Gut Feelings by renowned German psychologist Gerd Gigerenzer. In 2000, Gigerenzer and University of New South Wales economist Andreas Ortmann set out to construct a share portfolio based on the views of people who were largely ignorant of the sharemarket.
They randomly approached 100 people on the streets of Berlin and presented them with a list of 50 stocks. The shares that were most recognised were turned into a portfolio, which was submitted in a competition run by Capital magazine.
Markets hit a weak patch, but the portfolio based on "collective ignorance" made better returns than 88 per cent of others entered into the competition, including those from experts.
These results were not a one-off. Earlier work by Ortmann and Gigerenzer found portfolios put together by approaching people on the streets of Chicago and Munich also beat the pros most of the time.
More recent studies have failed to produce such stunning out-performance from punters. But at the same time they have not shown portfolios based around "recognition" to be bad.
So what could explain the strong performance of investment based on ignorance?
The behavioural economists reckon this is an example of the power of rules of thumb, or what psychologists call "heuristics". These are snap decisions we make without taking the time to weigh up all the pros and cons. In this case, the rule of thumb was to pick stocks with a familiar name.
It is important to stress that heuristics are not fully understood, and do not always lead to the right decisions. But the research shows they can be surprisingly effectively in producing mock investment portfolios. Why?
It may be because more "rational" decisions - in which we engage in deeper analysis - come with their own costs. Finding all the information takes time, and too much information can make us indecisive.
Rules of thumb can also do the job of filtering out the barrage of statistical white noise. To make this point, Gigerenzer refers to studies on asset diversification. To most people it is intuitively risky to put all your investments in one part of the sharemarket, such as mining. But exactly how you spread risk is a tougher question.
Advisers spend a lot of time and charge big fees to come up with recommendations on portfolio weightings. They might recommend investors go "overweight" on banks, for instance - meaning this sector plays a relatively important role in their portfolios.
Gigerenzer quotes studies, however, that show "optimal allocation" strategies worked no better than people just splitting their money evenly across a range of share portfolios.
A possible reason for this is that allocation strategies try to use historical data to predict the future. As Gigerenzer says, it is impossible to sort information that is useful for predicting the future from "arbitrary" information.
"Since the future is unknown, it is impossible to distinguish between these, and the complex strategies end up including arbitrary information," he writes.
Whatever the reason for the success of portfolios based on ignorance, one thing is fairly clear. Studies have shown up to two-thirds of mutual funds (after costs) will tend to perform worse than a market index - and Australia is no exception.
Through the fees charged by big super funds, most of us still pay the professionals to manage our money. But behavioural economics highlights that despite their expertise, this is no guarantee of superior returns in the long term.
The rapid growth in $450 billion self-managed super - it grew by a third in the past four years - suggests more people may be coming to the same conclusion.
Ross Gittins is on leave.