Why do do-it-yourself investors persist in building their own portfolios in spite of the evidence that they will likely underperform on a risk-adjusted basis?
Let’s chalk it up to the ‘IKEA effect’ so named for the Swedish furniture company that relies on customer labor to assemble their own furniture. From an article by Laura Spinney at New Scientist:
Economic orthodoxy dictates that we should place more value on items that spare us work. As we increasingly identify ourselves as money-rich and time-poor, we should be prepared to spend more of the former to save the latter. But humans and economic orthodoxy don’t always see eye to eye. “People have this very strong, internalised notion that effort equals quality,” says behavioural economist Michael Norton of Harvard Business School in Boston, Massachusetts.
This idea that more effect equals better outcomes or better quality seems to be inherent in us humans. However when it comes to investing there is no guarantee that more effort equals higher returns. One need only look at the hundreds of hedge funds that presumably work very hard to generate returns that go out of business every year. Most investors would be better off settling for mediocre, albeit better than average results, holding a well-diversified portfolio of low-cost index funds than trying to beat the market.
The IKEA effect may also explain why investors are so disconnected from the actual performance of their portfolios. Investors who build their own portfolios feel that their portfolios in some real way reflect on themselves. Therefore they are reluctant to take a good hard look in the mirror to accurately measure their performance. Again from the Laura Spinney article at New Scientist:
Kelly Herd, who studies marketing at Indiana University in Bloomington, identifies a third factor: a customised product takes on elements of the customer’s identity, reflecting them back to themselves. This, she thinks, could help explain the huge discrepancy between how people who have designed and customised an object rate them, and how other people rate them. “People create pretty objectively unattractive stuff but they love it,” she says.
The challenge for many is therefore recognizing that they are not their portfolio. This may also explain why some investors are reluctant to hand over their portfolios to a third-party even though that might lead to better performance. In so doing they miss out on the ability to gain some level of satisfaction from doing it themselves.
This would all be well and good if we really were just talking about the challenge of assembling cheap furniture. However when it comes to our portfolios we are talking about the ability to meet real world goals. So for those individuals determined to manage their own portfolios at least have the sense to track your own performance and recognize when that performance fails to live up to the most basic standards.