Why Do We Play a Loser’s Game?

Investors face a myriad of challenges today, including record low interest rates, stagnant growth in developed economies which are increasingly burdened by entitlement promises and growing debts, instability in the Middle East, and a level of uncertainty over tax and regulatory policy which is virtually unparalleled in history. But as daunting as these challenges are, they are not even close to their greatest threat. The most debilitating investment challenges lie within, and are compounded by the very financial  services industry they seek for guidance, an industry that is all too eager to capitalize on those weaknesses.

The first is that investors lack basic knowledge of how the capital markets work. So without an understanding of why the ups and downs occur, people fall prey to their own emotions, fanned by the sensationalism of the financial media, and worse, by the manipulation of self-interested financial product peddlers. Author Larry Swedroe observes that most investors seem unwilling to read the best books written on investing preferring to learn from financial network ‘gurus and the very industry representatives from whom they buy investment products.

Following closely behind the lack of knowledge is the extent to which we can fall prey to our human emotions. An inadequate understanding of the pitfalls inherent in the capital markets leaves investors vulnerable to several of the most powerful of human emotions – fear, greed, and the desire to be better than average. To be a better than average investor means to beat the markets. And conveniently, the vast majority of the financial services industry implies it can do just that for them.

In truth some can and do for a time. Problem is finding those who will do so in the future. Study after study shows that there is no difference between what the financial industry calls skill and what statistics proves is randomness or luck. But our focus today is not on how few managers and funds achieve market superior results, rather it is to examine why investors believe they can beat markets in the face of overwhelming evidence to the contrary, and why they allow their expensive advisors to continue trying one costly failure after another.

Why do most investors continue to play the game and why do even the strongest of converts continue to be drawn to the game even after leaving it behind?’ In his article On Magical Thinking and Investing Larry Swedloe quotes Kathryn Schulz, author of the book Being Wrong as saying “we are basically right, basically all the time, about basically everything.” And that “our indiscriminate enjoyment of being right is matched by an almost equally indiscriminate feeling that we are right. Occasionally, this
feeling spills into the foreground, as we … make predictions or place bets [or make investments].”

Schulz asserts that we view errors as external events, happening to others. She says “our beliefs are inextricable from our identities,” and “we’re so emotionally invested in our beliefs that we are unable or unwilling to recognize them as anything but the inviolate truth.  . . . we have a habit of falling in love with our beliefs once we have formed them. [and] being wrong can so easily wound our sense of self.”

Swedloe summarizes by saying, these observations “explain why we experience cognitive dissonance—the uncomfortable feeling and/or anxiety we feel when someone disproves a long-held belief. It also explains why we ignore evidence, even when it is compelling, and why we resist change.”

Margaret Heffernan, author of Willful Blindness observes: “We mostly admit the information that makes us feel great about ourselves, while conveniently filtering whatever unsettles our fragile egos and most vital beliefs.” She echoes Shulz when she says that while “love is blind, what’s less obvious is just how much evidence it can ignore.”

None of us likes to admit that we are wrong, particularly when that wrongness may have spanned many years and potentially cost us dearly in wealth and lifestyle. Swedloe shares his personal method for addressing the subject, that readers of past Briefs know are similar to my own. “When discussing the academic evidence on passive investing as the winning strategy, I have frequently observed that no one likes to be told they’ve been doing something wrong all their lives. To address this problem, I point out that I used to be an active investor [for 25 years in my case]. However, I did what all smart people do when they learn they are mistaken in their beliefs—they don’t repeat the mistake because that is the behavior of fools.” My message is not so rudely concluded.

Swedloe continues with Schulz’s observations that “our ability to forget our mistakes is keener than our ability to remember them. During her research, Schulz met many people who said she should interview them as they make mistakes all the time. Yet, when asked to give specific examples of their mistakes, they were hard-pressed to come up with any.” Shulz says that “we think our beliefs are based on facts and reason, and that we are rational. When we reject the beliefs of others, we think we possess good judgment. She calls this the Ignorance Assumption. She notes that at times it holds, but not always. And when the Ignorance Assumption fails, when people stubbornly refuse to agree with us even after we enlighten them, we move on to the Idiocy Assumption—they know the facts but they just don’t have the intelligence to comprehend them. And when that fails, there is always the Evil Assumption—people know the truth but have turned their backs on it.”

She concludes that “mistakes disturb us in part because they call into question not just our confidence in a single belief, but our confidence in the entire act of believing. When we come to see one of our own past beliefs as false, we also glimpse, for a moment, the persistent structural possibility of error: our minds, the world, the gap between them—the whole unsettling shebang. Swedlow extends this reasoning to conclude that “this is why Wall Street and much of the financial media fights so hard to suppress and reject the evidence that passive investing is the winning strategy—for them it is economic suicide.

Swedlow says “Investors, relying on the past performance of active managers, and rankings like Morningstar’s ratings, hire managers, then eventually fire most of them and repeat the process. They do so without ever asking: “What am I doing differently in the selection process so I don’t repeat the mistake I made last time?” In a triumph of self-justification, they end up doing what Einstein said was the definition of insanity—doing the same thing over again and expecting a different outcome.”

Back in July of last year I wrote a piece called the Tortoise and the Hare. It provides a wonderful picture of our basic desire to be ‘better than average’ and even to win what our minds tell us is a losers’ game. I’ve added an edited version of the story below. The original can be accessed by clicking on the link above or using the search box that always appears at the top right of most of our website pages. Our Briefs are archived all the way back to 2003 and offer sort of a financial journal of our last ten years together.

The Tortoise and the Hare

We have a natural affinity toward pizazz and speed in our selection of  investment options. We intuitively know that slow and steady will get the job done, but the faster ‘get rich quick’ options always seem so attractive.

Back in 560 BC or so a fellow named Aesop effectively portrayed our penchant for winning in his fable The Tortoise and the Hare. You know the story; the arrogant hare, while ridiculing the tortoise, was challenged to a race. After quickly leaving his challenger in the dust, the over-confident hare tires and decides to take a nap, only to find later that he has been passed by the steadily plodding tortoise.

But, even knowing the story, who would really bet on a tortoise in a race against a hare, except maybe Aesop or the tortoise? It just doesn’t make any sense. We seem to be naturally drawn to the speed and confidence of the hare. In the same way, in our investing, we are attracted to the hottest mutual funds and stocks. They are so much more appealing than plodding, boring index funds.

So let’s have a little race ourselves. If you could go back to 2000 and pick just one stock, knowing what you know right now, which one would it be? I’m guessing Apple would be top-of-mind for many. Since the beginning of 2000 Apple has generated a cumulative return of 2,232% or 29.3% annually. A sum of $100,000 invested in Apple on the last day of 1999 would be worth $2.3 million today.

Now let’s make this race really interesting. What if you were 65, ready to retire, and that you could go back to January of 2000, with perfect knowledge of how two investment choices would perform? You have $1 million and want to spend at least $80,000 of it annually. Your choice consists of a dull index portfolio consisting of 60% stocks and 40% bonds and cash or Apple. You are told that the 60/40 portfolio will earn 4.9% annually while recalling that Apple will return 29.3%. annually for the next 12 years. Which one will you choose?

If you succumbed to temptation and picked the Apple, I’ve got some bad news for you: in mid-July of 2007 you would receive a phone call from your advisor informing you that your account was fully depleted.

Alternatively, if you opted for the ‘tortoise’ portfolio, of 60% stock and 40% bonds, you would have plodded comfortably along, through 2007, 2008, 2009, 2010, 2011, and 2012. As of March 31st of this year, you would still have $197,308.


Data Source: Morningstar

As you look at the data above, the first thing that might surprise you is just how badly Apple got hit in 2000. Just a moment ago, when you were making your selection, you likely remembered 2000 was a tough time for tech stocks, but that stellar12-year return you heard about, likely helped persuade you to set 2000 aside as an ugly and horrible outlier. But as you look at the numbers more closely, see what a cost to lifestyle that‘ugly outlier’ inflicted. Your portfolio fell from $1,000,000 in 2000 to $266,430 in just a year.

Back to our metaphor: What a costly nap it was for our hare! But maybe all would not be lost. The following year’s 64% sprint might just get him back in the race, but alas, another rest stop of 31.2% would be required. Unfortunately from there, the race was over. Our hare ugh, Apple would never catch up, even with its blistering hops of 45%, 183%, 157%, and 25% in the years that followed.

The birds-eye view of the race shows that it was never really close.


The wisdom of Aesop’s Tortoise and Hare has been around for some 2,500 years to guide the investment practices of those who heeded. But wise investment counsel actually dates considerably further back. Speaking for God back in 920 BC, King Soloman wrote “The plans of the diligent lead to profit as surely as haste leads to poverty.” Proverbs 21:5.