Overconfidence

Behavioural Investing

July 6, 2017

Recently, we introduced the idea of behavioural investing as a subject for discussion and enquiry. We promised to explore the issue in more detail in subsequent blog posts and, this time, we will explore the concept of overconfidence.

Overconfidence is a human bias that is one of the most prevalent in influencing investment choices, according to Morningstar Inc., a global provider of independent investment research.

Are you as smart as you think you are?

Overconfidence refers to our boundless ability as human beings to think that we’re smarter or more capable than we really are. It’s what leads 82% of people to say that they are in the top 30% of safe drivers, for example.

Moreover, when people say that they’re 90% sure of something, studies show that they’re right only about 70% of the time. Such optimism isn’t always bad. Certainly we’d have a difficult time dealing with life’s many setbacks if we were die-hard pessimists. However, overconfidence hurts us as investors when we believe that we’re better able to spot the next Amazon.com (AMZN) than another investor is.

Studies show that overconfident investors trade more rapidly because they think they know more than the person on the other side of the trade. Although our own fees are scrupulously transparent, under most circumstances trading rapidly costs plenty, and rarely rewards the effort. We’ll repeat yet again that trading costs in the form of commissions, taxes and losses on the bid-ask spread have been shown to be a serious damper on annualized returns. These frictional costs will always drag returns down.

The illusion of control

One of the things that contribute to rapid trading, in addition to overconfidence in our abilities, is the illusion of control. Greater participation in our investments can make us feel more in control of our finances, but there is a degree to which too much involvement can be detrimental.

Fidelity International, in an online article published in December 2014, suggests that overconfidence becomes especially problematic in bull markets – whether in shares or bonds – and during periods of sustained stability. The article mentioned Hyman Philip Minsky (September 23, 1919 – October 24, 1996) who was an American economist, a professor of economics at Washington University in St. Louis, and a distinguished scholar at the Levy Economics Institute of Bard College.

Stability begets instability

Mr. Minsky was famous for observing that stability begets instability. His financial instability hypothesis suggests that people tend to take greater risks in periods of sustained stability. Minsky noted that some investors extrapolate stable conditions far into the future, encouraging them to put in place ever-more-risky debt structures.

Overconfidence in our own ability is most conspicuous in share markets just before a slump, but it can equally apply to other assets whose valuations may not properly reflect the risks.

Diversification

There is much to be said for considering the contrarian view and taking a range of outcomes into account. It’s a large part of why investors should have a diversified portfolio of risky and defensive assets. Diversification is a sleep-at-night solution to the problems stemming from overconfidence, and we recommend it.

The Wooding Group, 780 498-5047