Investing Psychology Chapter 5: Why Even the Experts Get It Wrong

When we get sick, we go to a doctor. When something breaks, we call a professional. So when it comes to investing, we hand our money to financial experts. Makes sense, right?

Here’s the problem. Your plumber might actually be more qualified than your investment adviser. Tim Richards opens Chapter 5 with this uncomfortable truth. Financial professionals often fall into the same biases we do. Sometimes worse, because their incentives don’t match ours. They get paid for their services, not for your success.

Welcome to the world of professional bias.

Mutual Funds Play Dirty With Data

But the real trick is how mutual funds make themselves look good. Richards breaks down several ways they cook the books:

Survivorship bias. Funds quietly merge underperforming funds into successful ones. The losers disappear from the record. Burton Malkiel showed that 15% of mutual funds vanished between 1988 and 1991. A UK study found that out of 1,008 funds in 1992, only 491 survived 11 years later. More than half, gone.

Instant history bias. Launch a bunch of funds quietly. Wait. Ditch the failures. Promote the lucky winner as proof of genius.

Backfill bias. New managers get added to reporting lists only after they already have a good track record.

The result? Performance exaggerated by up to 2% a year. Compounded over a decade, that’s over 100% difference. Historical mutual fund data is not a reliable guide.

Passive Investing Is Good, But Not Perfect

William Sharpe showed back in 1991 that actively managed funds underperform passive ones by the amount they charge in fees. Basic math. So index funds should be the default for most people. Richards agrees.

But here’s the thing. So much money is flowing into passive funds now that it’s starting to shape the market itself. When index funds buy stocks in proportion to their market cap, the biggest companies get even bigger regardless of their actual business performance. Morck and Yang found evidence that S&P 500 stock values are inflated partly because of indexing effects.

Index trackers are essentially parasites on active investors. They rely on active buyers and sellers to set fair prices, then just follow along. Classic free-rider problem. If passive investing becomes too dominant, this breaks down.

Does that mean you should avoid index funds? No. But diversify across different asset types, markets, and geographies. Don’t pile everything into one big S&P 500 tracker and call it a day.

The Dark Side of Institutional Trading

If you ever needed proof that markets are tilted against small investors in the short term, look at two things: high-frequency trading and dark pools.

High-frequency trading is where supercomputers buy and sell stocks in nanoseconds. These firms use relativistic physics to figure out server placement, because nanoseconds closer to the exchange means millions of dollars. They claim they “improve liquidity.” In reality, their systems discover the price you’re willing to pay and trade against you. In 2012, Knight Capital Group lost several hundred million dollars in minutes because of a bug in their program.

Dark pools are private markets where institutions trade anonymously at prices you can’t access. Sometimes traders use dark pool activity to move the real market against buyers.

But Richards makes an interesting point. You can’t compete on speed or access. So stop trying. Your real edge is time. Careful analysis and patience are the only skills you actually need.

Forecasting Is Basically Coin Tossing

Professional analysts get paid to predict earnings. Markets hang on their every word. And they’re almost always wrong.

Richards compares it to weather forecasting. Edward Lorenz discovered in the 1960s that tiny changes in starting conditions of a weather model produce wildly different results. That’s the butterfly effect. Financial markets work the same way. They’re complex adaptive systems that are fundamentally unpredictable.

Ivo Welch and Amit Goyal tested pretty much every forecasting technique out there: dividends, earnings, stock variance, inflation, bond yields, you name it. Their conclusion? None of them work particularly well.

Paul Soderlind found that a panel of economists showed zero ability to predict stock market movements, yet remained convinced they had real skill. That’s classic overconfidence bias at work.

Here’s a fun twist. Sometimes analyst forecasts are actually accurate. Not because analysts are good, but because corporations manipulate their own earnings to match the forecasts. Some firms use accounting tricks to avoid surprising the market. So when a company keeps hitting analyst numbers perfectly, that’s actually a warning sign.

Analysts Are Biased Too

Even if forecasting were possible, the forecasters themselves are biased. De Bondt and Thaler showed decades ago that analysts tend toward unrealistic optimism. They get rewarded for optimistic forecasts, so why stop?

Before the BP Deepwater Horizon disaster, analysts were uniformly positive about BP despite the company having the worst safety record of any oil major. Afterward, they herded together and adjusted in lockstep. Still too optimistic.

James Montier points out that analysts are terrible at seeking disconfirming information and bad at detecting lies. They mostly follow whatever corporate management tells them.

The magician James Randi used to write “I will die today” every morning and put it in his pocket. If he died, everyone would call him psychic. Financial forecasting works the same way. Make enough predictions and some will come true. J. Scott Armstrong calls this the seer-sucker illusion.

Women Are Better Investors (Sort Of)

Studies show women make better investors than men. Brad Barber and Terrance Odean found that men trade 45% more than women and make less money.

It’s not purely about gender. Durand, Newby, and Sanghani suggest it’s about attitude toward risk. People with aggressive risk attitudes trade more and lose more. That attitude is just more common in men.

Female fund managers are more risk-averse, more consistent, and achieve more stable results. They don’t hit sky-high returns, but they don’t blow up your money either. Overall returns between male and female managers aren’t significantly different. Yet women manage about half the funds men do. The industry rewards flashy risk-taking over steady performance.

Your Brain on Trading

Here’s where it gets biological. Trading triggers dopamine, the hormone tied to your brain’s reward center. It’s the anticipation of reward that gives the kick, not the reward itself. Same mechanism as gambling addiction.

Sapra and Zak suggest that since 90% of market trades are made by professionals, irrational market swings might partly be caused by a self-selecting group of dopamine-driven risk takers. More experienced traders tend to balance risk better over time.

If you find the thrill of trading exciting, you probably shouldn’t be doing your own investing. The most successful investors are calm and calculating. Not adrenaline junkies.

Key Lessons From Chapter 5 (Part 1)

1. Mutual funds manipulate historical data. Survivorship bias, instant history bias, and backfill bias make performance look better than it is.
2. Passive investing works, but diversify. Don’t pile into one big index tracker. Spread across asset types and geographies.
3. Short-term trading is rigged against you. High-frequency trading and dark pools exist for institutional profit, not yours.
4. Forecasts are mostly useless. Complex systems are unpredictable. Treat analyst predictions with serious skepticism.
5. Analysts are biased toward optimism. They get paid for it. Don’t outsource your thinking.
6. Steady beats flashy. Lower-risk, consistent approaches tend to produce better long-term results.
7. If trading excites you, be careful. Investing should be boring. If it feels like gambling, something is wrong.

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