A Little Knowledge Is a Very Dangerous Thing

Investing
You can trust that we maintain strict editorial integrity in our writing and assessments; however, we receive compensation when you click on links to products from our partners and get approved. Here's how we make money.

By Kenny Baer

Learn more about Kenny on NerdWallet’s Ask an Advisor

“A little knowledge is a very dangerous thing” – Alexander Pope An Essay on Criticism, 1709

Why does the general public believe that market timing is something that can be done consistently? What can this be contributed to?  What is it about the extremely complex financial market that makes so many people think that they have it all figured out?

The average person sees what the market does on a daily basis through either daily news sites or the nightly news.  This leads regular investors to believe that they know what is going on in the “market” because they see on a daily basis whether it is up or down.  Never does the news media relay back to the investor what it means for them.  If the investor gets wrapped up thinking about the direction of the market in the next day, next month, or even next year, then the most likely scenario is that the portfolio is not suitable to the goals of the investor. As Warren Buffett has famously said, “Risk comes from not knowing what you are doing.” Investing is done over years using complex formulas to minimize risk and maximize return.  “Avoid the noise”, says Jeffrey Gundlach, billionaire bond manager. Drown out the noise and keep your eye on the end goal, and what happens today in the S&P 500 should have virtually no effect on that.

As times have changed and trading has become easier then more and more investors have overtraded to the extent that it has eaten away at their performance in the long run.  According to Dalbar the average investor only returned 3.83% between the years of 1990-2010 while the market returned upwards of 9.14%.  This can be contributed to the “feeling” that dictates most investors decisions, not necessarily the security selection or portfolio construction. The temptation is just too great for most well-intentioned but yet unsophisticated investors to ignore.  If someone wants to lose weight then they are most likely capable of doing so, but it makes it a lot harder if everywhere that individual goes they are required to keep a piece of chocolate cake in their pocket.  Often times decisions are made based on a completely subjective nature.  Having a game plan and the discipline to stick with that plan regardless of the temptation can ultimately help the investor in the long run.  Author of “A Lifetime Guide to Mutual Funds” Chuck Jaffe offers great advice; write down why you make an investment when you make that investment, then look at that every time you think about selling.  Has the reason changed or have only the emotions changed?  Thinking long and hard about every decision made regarding investments is wise advice.

Some investors believe that they are able to outperform the market by choosing individual company’s common stock. This often leads to an over concentration of their portfolios in either too few positions or one sector.  Former CEO of JP Morgan Private Bank, Maria Elena Lagomasino, and current Coca-Cola board member said that “The biggest land mine to avoid in staying rich is the overconcentration in a particular investment; a single stock position has less than 50% probability of sustaining wealth over 20 years.  A diversified portfolio increases the probability to 85%.”  If an investor is picking individual securities then it is important to understand if the investor is being rewarded for taking on additional risk.  Think of it in terms of sport, would Lebron James consistently shoot 3 pointers from half court if he had a wide open lay up?

Taking the above mentioned advice or at least being aware of the advice can ultimately increase the return of the typical investor.   “One of the funny things about the stock market is that every time one person buys, another sells, and both think they are astute.” – William Feather