How Cockiness Destroys Your Portfolio

in Investing by

[dropcap]I[/dropcap]t’s not a stretch to say that many investors are proud of their strategies – we all like to think we’re the smartest people in the room every now and then. While confidence is a good thing, overconfidence is one of the most significant biases that investors have that are destructive to their investing results. Here’s why and what you want to look out for.

Overconfidence bias is the tendency to overestimate our abilities and our probabilities for success. In investing, it translates to feeling that we can pick winning investments better than others can, or feeling that we will know when to get into and out of an investment or even the market as a whole when others won’t. It’s a particularly dangerous bias because it’s almost always compounded with other biases.

As an example, I teach a behavioral finance class at the University of Denver to CPAs, attorneys, and financial planners. To illustrate a point, I ask the class to give me a range they feel 95 percent confident the stock market will return over the next year. I typically get two tendencies:

  • The midpoint varies from class to class following what the stock market has done over the past few months.
  • The range from low to high averages about 25 percentage points.

The first tendency illustrates “recency bias” while the second shows overconfidence. Using historic data, the range should be more than 80 percentage points. Clearly, we are overconfident in our ability to predict the unknown.

Examples of overconfidence

A few examples of the overconfidence bias I see every day are:

Emerging market stocks will outperform since their economies are growing faster.

This statement, which I hear all the time, is overconfident that few on the planet understand that Brazil, China, and India will grow faster and that prices aren’t already reflected in this common knowledge.

Interest rates will definitely increase this year, it’s just a matter of how much.

This statement was made by John Silva, the chief economist at Wells Fargo bank. He is one of 60 top economists who collectively have called the direction of long-term rates correctly well under half of the time. With such a track record, the word “definitely” showed extreme overconfidence.

I’m leaving 100 percent of my money in stocks because the bull will continue for some time.

This statement was made by a doctor trying to recoup his losses, just before the stocks started five consecutive months of declines.

Who is prone to overconfidence?

A famous study conducted by Terrance Odean and Brad Barber indicated that men are more prone to overconfidence bias than women. The study, Boys Will Be Boys, showed that men traded more often and had lower returns than women. Yes, men are more overconfident than women, and that makes women better investors.

I’ve found that physicians tend to be the single profession that makes the worst investors, though I have no scientific data to support it. My hypothesis is that they have the most overconfidence as they have already beaten the odds to become physicians and are treated almost “god-like” in our society.

The simple solution to being too sure of yourself is to become your own devil’s advocate. Ask yourself how you could be wrong in your investment conviction. If you can’t come up with at least a half dozen reasons, you are probably suffering from overconfidence bias.

Next, run your reasoning by people you trust, though tend to be a bit on the argumentative side. Keep in mind that you’re not looking for someone to agree with you, but rather looking for someone to counter your logic. Finally, never immediately act on your brilliant conclusion. The more time you spend noodling the investment, the greater the likelihood your rational brain will have a say rather than an action being driven by your emotional brain, without you even being aware.

 

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