This might be the most important investment statistic you ever hear…
Over a 20-year period ending in 2008, the S&P 500 index gained an average of 8.35% per year. The average investor, however, earned 1.87% a year. Not only do most investors underperform the market, but they do so with astounding vigour.
Why has long been a matter of debate. The most convincing answers usually come from the world investor psychology.
Emotions cause us to buy high and sell low. We think we can time the market. We act impulsively on rumours. We have very short memories. We're just not hardwired to be good investors. Terrible, actually.
A paper from the U.S.-based Centre for Financial Studies adds a twist to this discussion. The paper's conclusion might not be surprising, finding "that lack of understanding of economics and finance is a significant deterrent to stock ownership."
Even after controlling for age, education, and income, financial literacy has a profound effect on people's willingness to invest in the stock market. The more financially literate we are, the more comfortable we become around stocks.
That's how it should be, right?
Maybe. A separate paper by Lauren Willis at Loyola Law School (U.S.) adds yet another twist. Willis shows, quite convincingly, that financial literacy can actually be detrimental to people's financial health. A few examples:
"Data from the Jump$tart nationwide survey of high school seniors has consistently shown that financial education does not increase financial knowledge among high-school students and that students who take a personal finance course 'tend to do a little worse … than those who do not.'"
"A program to teach low- and moderate-income consumers about money management and Internet banking ascertained one year afterward that 'members of the treatment group were less likely to plan and set future financial goals at follow-up than they were at baselines.'"
"A study comparing bankruptcy debtors who received financial training with those who did not found that, once controls for other differences between the groups were added, the training was associated with a small negative effect on outcomes."
What's the deal?
Willis offers a few explanations. One, literacy itself isn't enough to overcome the emotional hurdles of finance. More importantly, financial education "appears to increase confidence without improving ability, leading to worse decisions."
Willis doesn't explicitly tie her findings to the stock market, but the jump seems logical: A major reason many investors fail at investing may indeed be because their financial education and literacy improve confidence without improving ability.
One good example: A study by Brad Barber and Terrance Odean found that investors "who trade the most realise, by far, the worst performance."
Those who think they're savvy enough to trade in and out of the market and for short-term profits almost invariably fail. Delusions of grandeur are one of the biggest poisons of successful investing.
The answer to this problem isn't to discourage financial education. Nor is it to discourage people from investing. It's acknowledging that the single most important aspect of personal finances and investing is not technical expertise, or even financial literacy.
It's understanding investor psychology, knowing our limits, having control over our emotions, and recognising the myriad biases we fall victim to.
Warren Buffett gets the last word: "Investing is not a game where the guy with the 160 IQ beats the guy with 130 IQ. What's needed is a sound intellectual framework for making decisions and the ability to keep emotions from corroding that framework."
This article, written by Morgan Housel, was originally published on Fool.com. Bruce Jackson has updated it.
