Individual Investors Do Worse

There’s a Slate story up reporting on a recent study showing that when individuals are given investment freedom, they make crappy choices:

Over the last 20 years, the stock market has averaged a 12 percent annual return. But according to a study by Dalbar Financial, individual mutual fund investors earned only about 4 percent. A survey by Vanguard finds participants in its 401(k) plans earn only about one-half the average´┐Ż6 percent a year. It is almost impossible to believe, and unpleasant to contemplate, but practically all individual investors are below average.

This point is not entirely new. We’ve known “forever” that individual fund managers tend to underperform the market; it’s one piece of the large package of related observations that make up the Efficient Markets Hypothsis Extended Remix. The article itself gets even deeper into the ironies of the situation, all of which seem to track quite closely post-EMH conventional wisdom that the smartest thing you (as an individual) can do is diversify and then leave your portfolio untouched. Anything else is uncompensated risk.

What the study adds, I think, is empirical evidence that indvidual investors haven’t absorbed this learning. They underdiversify; they churn. The result is that people with great freedom in their investment choices can be expected to do much worse, on average, than people whose investments are made for them.

In short, we’re looking at one of those places where liberal economic theory just plain goes off the rails: people tend to be better off when they’re deprived of a certain kind of freedom. What to do about it is an ugly, ugly question. The paternalistc answer would be to say that we shouldn’t be allowed make our own investments: professionals should be appointed to run them for us.

But that answer’s not acceptable, for various reasons. There’s the libertarian reply, that you can’t morally deprive someone of freedom just because they’ll use that freedom in a way that hurts only themselves. There’s the entreprenuerial reply, that it’s unfair to deprive those people who can beat the market of the chance to do so, just because others are not so wise. And there’s the managerial reply, that the only reason we have a market that works so well is that investors have autonomy.

Of course, none of these replies is conclusive; we can go through a whole process of rejoinders and rebuttals and so on and so forth. The anti-libertarian might observer that we deprive children of the freedom to make bad choices; the anti-entrepreneur will point out that under the EMH, the market-beating enterpreneurs are merely extraordinarily lucky, not extraordinarily skilled; the anti-manager will observe that there are other techniques (e.g. elections) for constraining managers other than the freedom to uninvest. The debates are endless.