Are Your Children and Investments Above Average?
In the fictional town of Lake Wobegon, all the children are above average. Yet that is statistically impossible. It illustrates a common cognitive bias called illusory superiority, whereby we all overrate our abilities and overestimate our achievements.
Although it may be psychologically healthy to accentuate the positive, in the realm of investing, it can lead to dangerous errors. Investors need to be clearheaded about their skills and edge, if any, and ready to learn from past mistakes.
Humility is your friend
Do you get on better with people than average? About 80% believe they do. Social psychologists have performed experiments in diverse fields to examine the phenomenon of overconfidence. Classic studies conducted in the 1960s asked drivers to assess their own skills, and they overrated them. That attitude is perilous because it leads to an inflated sense of security in place of methodical caution.
Financial strategist James Montier surveyed 300 fund managers to learn whether they ranked themselves as above average. Among the group, 74% believed they were, and 26% more modestly described themselves as average. Almost no one admitted to being below average, but then, perhaps they were concerned with maintaining their professional reputations!
There are two branches to this misplaced optimism. On one hand, investors and others overvalue their rank according to some specified dimension, like intelligence or memory. On the other, they misjudge their precision, as in stock market returns. Underlying both sets of beliefs is another bias: self-attribution: When their decisions pan out, they credit their own brilliance, but when they flop they blame bad luck.
Investors compound these self-serving illusions by setting overly narrow confidence intervals around their forecasts. To prop up their convictions, they look for confirming evidence and ignore contradictory signals.
One logical implication is that we’re left with a futile pursuit of active trading. Since it is generally accepted that it is difficult to keep beating the market, does that mean any active trader is overconfident to some degree?
What makes us so cocksure?
There are several reasons we stubbornly cling to our exaggerated self-worth.
First, it works in many walks of life — though not for investing. For example, confidence may prove an effective career strategy, even in investment management positions. It is generally likely to be productive to act and think in a positive framework. We absorb cottage wisdom everywhere, urging us not to dwell on our past mistakes but to dust ourselves off and put our best foot forward.
An insidious culprit may be selective memory. Humans appear hardwired to distort past experiences and transform them into a rosier light. For instance, when subjects are asked about their old college grades, they tend to remember them as higher than they were. The opposite is true of their cholesterol levels, which they are likely to downplay in retrospect. Further, a study of 215 online investors discovered respondents could not correctly recall their own past portfolio performance, overrating it by 11.5% a year.
To make matters worse, selective forgetting increases with normal aging. Nor are the decisions made by groups like investment firms likely to be any better. Actually, groupthink may prompt them to embolden one another.
How to curb your enthusiasm
Too much confidence encourages poor investment practices: overconcentrated portfolios, insufficient diversification and a reliance on active managers in the belief that they can consistently outperform. Individual investors can nevertheless practice self-discipline to rein in their complacency.
- Think foremost in probabilities, not single-narrative stories. Probabilities will make you more open to flexible views and to shifting them with new information.
- Look at your old statements critically. Review your gains as a percentage of the portfolio, compare your returns to relevant benchmarks and calculate where you would now be if you had not traded.
- Look for an outside view using evidence from relevant reference groups and not your own experience.
- Don’t overtrade. Average turnover for men is 1.5 times higher than for women, an interesting sign of overconfidence.
Heightened awareness can mitigate potential damage to your returns. Your financial adviser can be an ally in helping you avoid behavioral traps.