Why Most People Are So Bad At Stock Picking (and what does Howie Mandel have to do with it?)

Photo credit: jb

You know the old game show “Deal or No Deal”, right? If you aren’t familiar with it, here’s a basic rundown of the premise: the contestant is faced with 26 briefcases, each with a dollar amount inside, ranging from one penny up to one million dollars. At the beginning of the show, the contestant chooses one of the cases as her prize. Howie Mandell was the original host of the show – I don’t know if it still exists these days but it’s a classic example.

The amount in the case she has chosen remains secret until the end of the show. Then the contestant begins eliminating the remaining 25 cases – first in groups of larger numbers, then fewer at a time, and finally one at at time. As the cases are chosen, the amount in each case is revealed. At the end of each round of reveals, a mysterious character called “the banker” offers the contestant a sum of money to drop out of the game.

The amount that the banker offers seems random, but it is actually relative to the amounts that have yet to be revealed: if more high-dollar amounts are remaining to be revealed (which means a high-dollar amount could be in the contestant’s prize case), a relatively higher amount is offered. If the amount offered is attractive enough to the contestant, she can choose to take that amount, quit the game and walk away. If the contestant refuses the offer, she will have to choose another case and reveal the amount.

As the match progresses, often we see the contestant choosing cases that reveal high dollar amounts in them – which prompts the banker’s offer to reduce. Even when faced with seemingly impossible odds against her, when this situation occurs, the contestant often becomes a risk-taker – more so than you would normally expect.

This is because the contestant feels as if she has already lost something (the earlier offer from the banker) and somehow she must make up the loss by continuing the game in spite of the odds becoming less and less that there is a large amount in her chosen prize. Statistics will rule, and on average the contestant walks away with a much smaller prize than expected.

So what does this have to do with investing?

Quite often we see the same sort of behavior in the stock market: always trying to do better than the average, folks will use all kinds of methods, including paying extra to get the top dog stock picker’s advice – because they’re sure they can beat the market. And then, if the chosen stock shoots up in value, the investor hangs on, knowing that if it went up 10% it is bound to go up another 10%. But what happens when the stock goes on up to 20%? Yep, hang in there, cuz it’s bound to keep up.

Then suddenly the stock pulls back, and now is down 5% from the original investment – what happens now? This is just like when the banker on Deal or No Deal reduces his offer: the investor feels like she’s lost something that she already had in hand, so she begins to take even more risks. Perhaps she’ll buy some more of the stock – again, knowing she’ll make up the losses with future gains. But it rarely works out for the hapless investor.

The problem is that the investor didn’t go into the investment with a plan – and the same would hold true for a contestant on Deal or No Deal. If you decided that you were shooting for a 10% return from this particular stock, you’d have sold out at that level and could have gone looking for the next great option. Without a plan, you never know when to get out of the position.

A Plan!

If a contestant were to go into the show with the plan that she’d like to do better than average – the first time the banker offered more than $131,477.50, she should take it. ($131,477.50 is the average of all the amounts in suitcases.) That would be an excellent strategy to take, especially when you consider the fact that 20 of the 26 cases have less than the average of all the cases taken together.

As an investor, the odds are much better for you, using history as a guide. If our investor chose to take a shortcut and get a return that is at least the average of the stock market – since in the last 40 or 50 years the stock market has only returned a negative roughly 20% of the time, using the average would assure you of a positive return 80% of the time. That’s much better than the results of the average Joe or Jane who plays an active stock picking game.

To get the average of the overall marketplace, the investor can choose to invest in broadly-diversified indexes, covering domestic and global markets. This is a very cost-effective way to achieve the average – and with such a strategy you don’t have to worry about when to get in or get out, or even shout “NO DEAL”. Go for it, and hang on for the wild ride of average returns. And if you want a fist-bump, fine, come by my office, I’ll be happy to oblige.