“We don’t like complexity and we distrust other systems and think it many times leads to false confidence. The harder you work, the more confidence you get. But you may be working hard on something that is false. We’re so afraid of that process so we don’t do it.”
Do you believe you are a great investor?
And if so, then why haven’t you made millions yet? Why aren’t you making the kinds of returns you thought you would / or that you should? Why aren’t you even generating the returns of the general market?
This doesn’t mean you are a lousy investor either. In fact, you may even feel very confident that you are making the right investment decisions, and you probably have all the right skills to research your stocks and properly analyze a financial statement (very rare). You may even be paying the best possible commissions when it comes to your broker. The problem is not your skill, it’s your brain…
The human mind is an odd, very complex and amalgamated device. And it also has a number of hardwired functions that help us in terms of our overall survival, however, we aren’t cavemen anymore and the world is changing at a much faster pace than our brain can keep up with on a daily basis. This means that making investment decisions (or any decision for that matter) that are intelligent can be very difficult.
In fact, your brain could be killing the success of your portfolio. And although there are a number of traits that are causing this, one of the biggest mindset flaws in investing is overconfidence. Unfortunately, overconfidence affects a wide range of people (especially the smart ones).
According to Charlie Munger,
“Similarly, the hedge fund known as ‘Long-Term Capital Management’ recently collapsed, through overconfidence in its highly leveraged methods, despite I.Q.’s of its principals that must have averaged 160. Smart, hard-working people aren’t exempted from professional disasters from overconfidence. Often, they just go aground in the more difficult voyages they choose, relying on their self-appraisals that they have superior talents and methods.”
Overconfidence and Overtrading
Research has demonstrated two key things. The first is that those who overtrade tend to have the poorest results. The second issue is that people who overtrade tend to be overconfident as well. A 2006 study by Brad Barber and Terrance Odean found that “Of 66,000 households trading through a large discount brokerage, showed that over a five-year period, the most active investors, on average, underperformed a range of benchmarks.”
Overconfidence is also strongly seen in CEOs of large corporations. They are convinced that their vision is the right one and they force their opinions through in the firm belief that they are right. These are the very companies that see their stocks plummet, because they make bad decisions and reach for growth at any cost initiatives. Interestingly, overconfident investors seem to purchase stocks in those types of companies, and this includes fund managers.
“In a 2006 study entitled “Behaving Badly”, researcher James Montier found that “74% of the 300 professional fund managers surveyed believed that they had delivered above-average job performance. Of the remaining 26% surveyed, the majority viewed themselves as average. Incredibly, almost 100% of the survey group believed that their job performance was average or better. Clearly, only 50% of the sample can be above average, suggesting the irrationally high level of overconfidence these fund managers exhibited.”
A False Sense of Security
Basically, investors lure themselves into a false sense of security. Investors who suffer from overconfidence think their gains are due to skill, instead of recognizing that rising stocks are lifting everyone’s portfolios.
A classic example of this is seen in the stocks of social media. When it was first announced that the biggest social media platform, Facebook, was going to IPO on the market, predictions and sales presentation overly hyped the offering. This failed massively and people actually lost a lot of money on what was supposed to be a “sure win” as people panicked and sold during the sell-off after the IPO.
It is this very confidence in sure wins and in an investor’s capability of predicting things that has caused the issue in the first place. Overconfidence bias stems from an investors inability to see true value in a business, and then attributing market returns to personal skill and decision-making ability. However, when stocks decline it is not their fault; it’s due to ‘external’ market forces.
Just take a look at your typical internal dialogue of an Investors’s mind:
How Does Overconfidence Hurt?
We are told in life that we must be confident in our own abilities. The idea of overconfidence is something that is generally reserved for people who believe they are more than capable of doing something when the reality is they are no better than average person (perhaps even worse). This is applicable to investors, too. The reality is that overconfidence is truly damaging to your portfolio. The biggest hurdle for people who have too much confidence is to understand that something that they believe to be true is sometimes simply false.
Overconfidence can cause an individual to see his/her own thoughts as rational and objective, and yet, see other people’s decisions as subjective or emotional. When you become too confident, you are no longer able to see any evidence that proves your opinions are actually incorrect. It is important to develop strategies, systems and checklists as an investor to ensure you are attentive to the facts and evidence that are presented.
Having a healthy dose of confidence is a good thing, as it will allow you to make decisions. However, being overconfident increases the probability of making rash decisions over the long run. Stick with a rational and repeatable system of checklists and mental models, and never stop learning.
Barber, Brad M. and Odean, Terrance. 2000. Trading Is Hazardous to You Wealth: The Common Stock Investment Performance of Individual Investors. The journal of Finance.http://faculty.haas.berkeley.edu/odean/papers%20current%20versions/individual_investor_performance_final.pdf
Montier, James. 2006. Behaving Badly. Social Science Research Network. http://papers.ssrn.com/sol3/papers.cfm?abstract_id=890563
Featured Graph Credit: Safal Niveshak