The curse of Overconfidence in investing

Jun 24, 2019

If you are even remotely interested in behavioural finance, you would have come across studies that invited readers to answer questions along the lines of: Am I better than average in getting along with people? Am I a better-than-average driver?

The results would have the majority answering positively to such questions. Ironical, because only half can be better than the average. But aren’t we a cocky and confident species?

Investment Titans author Jonathan Burton puts forth the Golden Rule of Investing: Don't be overconfident. The rest is commentary. Every investment mistake is rooted in overconfidence.

He is not alone. In his book Thinking Fast and Slow, Nobel laureate Daniel Kahneman called overconfidence “the most significant of the cognitive biases.” Around four years ago, in an interview with The Guardian, Kahneman once again expressed his view that the most damaging of biases that plague an investor is overconfidence. He said then that it is the bias he would most like to eliminate if he had a magic wand. But it “is built so deeply into the structure of the mind that you couldn’t change it without changing many other things”.

The Wiley Blackwell Handbook of Judgment and Decision Making referred to overconfidence as the mother of all biases that give other decision-making biases teeth. No problem in judgement and decision making is more prevalent and more potentially catastrophic than overconfidence. Overconfidence has been blamed for, among many other things, the sinking of the Titanic, the nuclear accident at Chernobyl, the loss of Space Shuttles Challenger and Columbia, the subprime mortgage crisis of 2008 and the great recession that followed it, and the Deepwater Horizon oil spill in the Gulf of Mexico.

Can you see the danger lurking behind overconfidence?

In the investing arena, overconfident investors will risk far more money on a venture than their less confident counterparts. Overconfident investors will bet way too much on a particular stock or a trend. They might also hang on to an investment confident that it will bounce back even if the best decision is to beat a hasty retreat. Recently, this was evident in Jet Airways, where individuals I know who were invested in the stock refused to exit because of their supreme confidence that the government will not allow such a big airline to fail. Studies show that overconfident investors trade more than rational investors and that doing so lowers their expected utilities. Greater overconfidence leads to greater trading and to lower expected utility.

Overconfidence gives us the courage to act on our misguided convictions and this leads to suboptimal investment behaviour.

Why do we fall prey to the narrative of overconfidence? Because we don’t want to be proved wrong. Because we are innately averse to uncertainty. Because we have an extremely high opinion of our intuition and knowledge.

Studies by Don Moore gives one much more clarity on the subject. He explains that overconfidence is not a single unitary construct, and is manifested in three ways, depending on the circumstances and the trigger:

  • Overestimation is thinking that you are better than you are.
  • Overplacement is the exaggerated belief that you are better than others.
  • Overprecision is the excessive faith that you know the truth.

Beating overconfidence to be a winner

1. Your best bet to overcome the pitfalls of overconfidence is to slow down your thinking and simply become aware of it, and question whether you’re maybe being overly optimistic. Don’t act in haste.

2. Be confident, yet intellectually humble. Consider the possibility that you could be wrong. Listen to evidence that could possible change your mind. Be ruthless with your investment thesis. Be open-minded.

3. Consider the consequences of being wrong. Your job should be first and foremost not to lose money. Put your ego aside and keep that in mind.

4. Don’t view each problem in isolation. The single best advice we have in framing is broad framing. See the decision as a member of a class of decisions that you’ll probably have to take.

5. Don’t underplay regret. Regret is probably the greatest enemy of good decision making in personal finance. So if you are an asset manager or financial adviser, assess how prone clients are to it. The more potential for regret, the more likely they are to churn their account, sell at the wrong time, and buy when prices are high. High-net-worth individuals are especially risk averse, so try to gauge just how risk averse. Clients who have regrets will often fire their advisers.

6. Seek out good advice. Part of getting a wide-ranging perspective is to cultivate curiosity and to seek out guidance. An ideal adviser is a person who likes you and doesn’t care about your feelings.

The last three suggestions (4, 5, 6) have been taken from Daniel Kahneman’s talk at the 71st CFA Institute Annual Conference in Hong Kong.

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