Thursday, March 15, 2007

Lake Wobegon Stock Exchange: Where All the Returns are Above Average

In the last few years, quite a few of the companies we use have started publishing glossy mags, especially investment services - probably to keep us Baby Boomers paying attention, especially to our retirement accounts. I usually glance at them, and often find something interesting amidst the tables, graphs and lingo-filled articles on "Mid-and Small Cap U.S. Stock Funds". (I suspect there's a PR person somewhere who instructs the staff to throw in something for the English majors.)
Charles Schwab's magazine had a fascinating article on a new area of research, Behavioral Finance, which studies the irrational behaviors people exhibit when it comes to money. While some of them are heartbreaking, a lot of it is pretty funny. My favorite in the article is "The Lake Wobegon Effect", when according to the author, Greg Forsythe,

Most investors believe their portfolios will perform better than market averages -- a statistical impossibility since the market is the average of all investors. This is sometimes referred to as the "Lake Wobegon Effect", or the tendency to overestimate one's achievements and capabilities in relation to others.
Another behavior is panicking and selling when the market tanks, even though taking risks in order to achieve larger gains is the whole point of investing in the stock market. A wise broker once told me, "When the market is down, stocks are on sale. It's a great time to buy!" But a wiser investor [who will not get a commission] would say, Go with the Index Fund, since you're never gonna beat it.
One irrational financial behavior that has always amused me is people standing in line to buy lottery tickets when the pot gets to be several hundred million dollars. Their chances stink no matter what the pot; it's only worth it for 250 million? For 25 million it's not worth buying a ticket?

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