Why investors don't do as well as the market

In his book, Your Money, Your Brain: How the New Science of Neuroeconomics Can Help Make You Rich, the journalist Jason Zweig describes an experiment.

In the experiment, researchers flash two lights, one green and one red, onto a screen. Four out of five times, it’s green; the other time, the red light flashes. But the exact sequence is kept random.

When rewarded for correct picks, rats and pigeons quickly discover the best strategy is to always pick green, guaranteeing an 80 percent correct-pick rate.

Humans, however, tried to anticipate when the red light would come on. This misguided strategy, on average, leads people to pick the next flash accurately only 68 percent of the time.

Stranger still, humans persist in this behavior even when researchers tell them the flashing lights are random. And while rodents and birds quickly learn how to maximize their score, people often perform worse the longer they try to figure it out.

What does this mean for investors? Financial planner Stan Johnson:

Humans often see what they think are long-term trends but base their analysis on short-term data. Many credible studies show the average investor underperforms the market, some by as much as 6 percent per year, and this illustrates how it happens. Right after an investment generates strong returns, people tend to jump on the bandwagon. When an investment is struggling, people tend sell out and miss the recovery.

Be a bird brain.