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Cutting errors

A team of economists at Goethe University in Frankfurt studied 5,000 German investors between 1999 and 2011 and found that, on average, the shares that they bought underperformed the market in the following month. This implies that the average investor can't spot good short-term share performance - a finding consistent with previous research by Brad Barber and Terrance Odean, two US economists who have also showed that investors, on average, underperform the market.

What's more, even above-average ability to spot short-term winners doesn't do much good. The team estimate that short-term stock-picking skill of one standard deviation above-average - equivalent to moving from average ability to just outside the top one-sixth - is associated with only 0.4 percentage points of higher risk-adjusted annual returns.

If you think this is surprisingly small, look at it from the perspective of the efficient market hypothesis. This says that all shares are properly priced and so there should be zero risk-adjusted returns to skill; if there's no fish in the sea, even the best fisherman won't catch anything. This hypothesis isn't wholly correct, because there is a positive return to skill. But the fact that this is low is consistent with the possibility that the efficient market hypothesis is largely true.

However, this doesn't mean there is nothing investors can do to improve their performance. There is. The researchers found that investors make two avoidable errors.

One is that they own too many lottery stocks - ones with low prices and skewed returns such that there's the small chance of big rises. Such stocks are on average overpriced and so underperform the market. Cutting out such stocks, the team estimate, would increase annual returns by just over 3 per cent a year.

The other error is that some investors are under-diversified, owning only one or two stocks. This isn't a big mistake if you can spot great stocks - because if you can do so, diversification merely dilutes returns. But it is an error if - like the average investor - you have negative stock-picking skill, because it concentrates your losses. For these investors, diversification cuts losses.

There's a footballing analogy here. A big reason why Arsenal have improved so much in the last 12 months isn't so much that they are playing more brilliant football, but that they've cut out most bad defensive errors. Reducing incompetence, more than increasing positive skill, can reap big rewards.

There's something else. The researchers also found that differences in risk exposure explain twice as much variation across individuals' returns as do differences in investors' skills. This implies that the investing environment matters more than our individual abilities - a fact which that pernicious cognitive bias the fundamental attribution error is apt to blind us to. For some of us, though, this is a good thing.