Wealth doesn’t guarantee investment expertise. Yes, even millionaires make mistakes.
A recent working paper from the National Bureau of Economic Research challenges the assumption that the wealthy are inherently adept investors. The study involved 2,484 individuals in the U.S. with a minimum of $1 million for investment, and sometimes considerably more.
Through two comprehensive surveys, researchers assessed the alignment of these millionaires’ financial beliefs and actions with prevailing academic market theories.
Astonishingly, the findings unveil that the affluent commit similar investment blunders as the general populace, and perhaps a few additional ones.
James J. Choi, co-author and Finance Professor at Yale School of Management, emphasizes that financial acumen doesn’t automatically accompany wealth. “Being affluent doesn’t guarantee infallible financial judgment,” notes Choi, underscoring the fallibility of assuming the well-off possess exclusive financial insights.
Here are 4 common investing mistakes millionaires make.
What you'll learn:
1️⃣ Lack of Diversification
Research highlights a conspicuous trend among investors: 15% of participants currently allocate over 10% of their net worth to a single company’s stock, foregoing the diversified approach recommended by financial experts.
This tendency aligns with findings from other studies, reinforcing the notion that wealthier individuals exhibit higher investment concentration. Although exceptions exist (such as company CEOs bound by contractual obligations to retain significant stock), the majority of investors, including the affluent, generally adhere to conventional diversification principles.
The inclination to diverge from this norm often arises from an overestimation of personal insight. Notably, a staggering 46% of respondents with substantial stock concentrations indicated a strong belief in higher returns from the chosen stock compared to others.
Yet, this conviction may be misguided, cautions James J. Choi. He suggests that this apparent skill might be attributed to luck rather than genuine expertise, akin to lottery winners being affluent, not necessarily skilled at predicting numbers.
Ultimately, the allure of higher returns can lead to investment misjudgments, underscoring the necessity for prudent diversification strategies.
2️⃣ Disregard for Value Stocks
Even affluent investors occasionally falter in their assessment of risk and reward dynamics. A notable revelation is that almost half of wealthy participants (47%) perceive value stocks—those with low price-to-earnings ratios—as less risky than growth stocks.
Furthermore, a higher proportion (24%) believe value stocks yield lower average returns compared to growth stocks (22%).
Ironically, historical data demonstrates the opposite: value stocks have consistently generated superior average returns compared to their growth counterparts.
Additionally, value stocks exhibit lower risk levels, evidenced by the “beta” metric—a renowned mathematical concept gauging a stock’s volatility relative to the broader market.
The divergence between wealthy investors’ perceptions and actual market realities emphasizes the significance of informed decision-making, particularly concerning investment strategies involving value stocks.
3️⃣ Neglecting Momentum Stocks
Wealthier individuals also display a propensity to erroneously perceive high-momentum stocks as yielding lower average returns in comparison to higher average returns (27% versus 11%).
Contrarily, empirical evidence demonstrates that high-momentum stocks—those that have experienced significant price increases over the preceding year—tend to outperform stocks that have witnessed substantial price declines during analogous periods.
Curiously, a previous study encompassing a cross-section of the U.S. population revealed a converse pattern: a larger proportion of average Americans believed high-momentum stocks offered higher average returns.
In this context, “the average Joe seems to have a more accurate grasp than the wealthy,” notes Choi.
The rationale behind the wealthy harboring beliefs that defy historical data remains elusive. Equally uncertain is whether these perceptions influence their investment choices, as the survey does not measure whether these misconceptions translate into actionable decisions, according to Choi.
4️⃣ Excessive Trust in Investment Managers
Interestingly, the affluent also exhibit a pronounced inclination to place excessive faith in Wall Street. Within the subset of participants who have engaged in active investment strategies through funds or professional managers, 45% emphasize the significant influence of recommendations from hired investment advisors.
Concurrently, 43% attribute utmost importance to the belief that an active investment strategy, as opposed to a passive one, would secure higher average returns.
Contrastingly, historical evidence reveals a contrasting reality: the majority of active funds have consistently underperformed market indexes. Illustratively, during the year concluding in March 2020, 72% of domestic equity funds experienced underperformance—a slightly exacerbated scenario compared to the preceding year-end 2019 results (70%), as indicated by S&P data.
James J. Choi underscores the inherent difficulty in predicting the performance of funds, shedding light on the challenge faced by investors in identifying consistently successful options.