Investing Psychology Chapter 5: The Professional Magic Show (Part 1)
When we have a toothache, we go to a dentist. When we have a legal problem, we call a lawyer. So when we have money to invest, we go to a professional, right?
In Chapter 5, Tim Richards warns us that financial “experts” are the only professionals who aren’t really overseen. Your plumber might have better qualifications than your investment advisor. And worse, their incentives are usually the exact opposite of yours.
Mutual Fund Magic Tricks
Mutual fund companies are masters of survivorship bias. They’ll launch ten different funds, wait five years, and then quietly close the seven that lost money. Then they’ll take the three that got lucky and market them as “consistent winners.”
They also use instant history bias—launching a fund, waiting for it to have a good year, and then opening it to the public so it looks like it’s always been a star. Don’t be fooled by historical data. It’s often just a curated highlight reel of luck.
The Problem with “Passive”
I’m a big fan of index funds, but even they have a dark side. As more people move into passive indexing, the biggest stocks in the index get bought regardless of their value.
This creates a bubble where the biggest companies just keep getting bigger because everyone is “blindly” buying the index. Eventually, this hits a wall. Indexing is a great tool, but don’t assume it’s a magic bullet.
High-Frequency Predators
The institutions are currently in a “nanosecond arms race.” They’re using relativistic physics to place their computers as close to the stock exchange as possible to gain a tiny edge in speed.
They use “dark pools” to trade anonymously and high-frequency algorithms to front-run your orders. In the short term, the game is rigged. You cannot win a speed race against a supercomputer. Your only edge is to stop playing the short-term game entirely.
The Butterfly Effect in Earnings
Analysts are paid to predict the future. The problem? Markets are “complex adaptive systems,” which means the tiniest change at the start leads to a massive difference at the end. This is the butterfly effect.
Most earnings forecasts are a triumph of accounting over reality. Analysts are almost always too optimistic because being a “bear” doesn’t sell products. They herd together for safety, usually missing the “car crash” until it’s already happened.
The Lesson
Stop treating financial advisors like doctors or scientists. They’re often just salespeople with better software. In the next post, we’ll look at why you should probably trust a married woman with your money more than a single guy.