Irrational Investors

In a very good column, Henry Blodget details some insights from behavioral finance into  the biases individuals must overcome when choosing to invest in the stock market, including self-attribution bias, the gambler's fallacy, confirmatory bias and outcome bias. Especially worthwhile is his relation of how a paper by Michael Maubossin lays out just how strong the human tendency to follow the herd is, even when the majority is so clearly wrong.

It's been my experience that even trained professionals who ought to know better find it difficult to overcome these psychological blinkers when faced with investment decisions, and if unmanaged indexed funds have one great virtue, it is that they at least aren't subject to such biases; they don't panic when stocks fall, don't buy into fads like the "Nifty 50" or "dotcoms", and they don't convince themselves that success which owes mostly to luck is actually a marker of their genius, and therefore deserving of fat commission fees.

Comments

[dsquared]

Index funds do buy into "Nifty Fifty" and similar ideas because they're market cap weighted. The S&P500, in particular, massively increased the MSFT weighting almost exactly at the top tick.

I've written a few squibs in the past about the popular confusion between "buy and hold" and "index funds" and the belief that the two are the same. I probably ought to do a longer piece.

[Abiola Lapite]

"Index funds do buy into "Nifty Fifty" and similar ideas because they're market cap weighted. The S&P500, in particular, massively increased the MSFT weighting almost exactly at the top tick."

Yes, you're correct. I should have qualified my statement by saying that index funds aren't as likely to fall full-throttle for such fads as the worst fund managers; even at the height of the tech bubble, there were still quite a few "old economy" stocks in the S&P 500, so the post-bubble loss wouldn't have been quite as bad as with a fund which was mostly invested in "new economy" stocks.