Everyone is Average

I just read The Undoing Project by Michael Lewis, which tells the story of Daniel Kahneman and Amos Tversky, the founders of what we now call behavior economics. Tversky died in 1996, but Kahneman went on to win the Nobel Prize in Economics in 2002. However, neither of these men is an economist—they are psychologists. But it is in the collision of these two fields that we discover why people make decisions that often make little economic sense.

For example, in one series of experiments they discovered that people often rely on certain factors to gain confidence in their predictions that actually lead to less accurate results. In the study, they would tell participants that they have selected an individual’s profile from a group of 100, which is made up of 70 engineers and 30 lawyers. When asked to predict the odds it was a lawyer’s profile, participants correctly answered 30%.

However, when given a detailed yet completely generic personal description of an individual named “Paul,” participants said that there was an equal chance of Paul being a lawyer or engineer. In effect, they completely dissociated their prediction from the known probabilities. Participants felt like they “knew” Paul, which made him special, but Paul had the same 30% chance of being a lawyer as any other profile. In other words, Paul was average.

Now, transfer this insight into how people pick investments. People pour over reports, ratings, and returns, for individual stocks and mutual funds, but at the end of the day, every fund manager is a Paul—they are just average. In the book, Lewis notes that, “Man’s inability to see the power of regression to the mean leaves him blind to the nature of the world around him.”

That’s not to say that there are no great investors. It’s undeniable that someone as consistently successful as Warren Buffett is absolutely a great investor. But there’s only one Warren Buffett, and there are countless fund managers, half of whom will beat the market and the other half won’t. So is it worth the cost of buying expensive and actively traded mutual funds just to have a 50/50 chance of beating the market?

I don’t think so, and neither does Buffett:  In his 2013 annual letter to stockholders, he wrote that, through his will, he has directed the trustee of his estate to invest in S&P 500 index funds. Buffett knows that active fund managers will always talk about “seeking alpha” and their “tactical allocations,” but they will all eventually regress to the mean.

It’s not sexy, and it forces investment managers to admit that we don’t have a crystal ball, but passive investing through a balanced portfolio of low-cost, index funds is the way to go.


Josh Norris is an Investment Advisory Representative of LeFleur Financial. Josh can be reached at josh@LeFleurFinancial.com.