29 May The Perils of Overconfidence
“Don’t you know about the praying mantis that waved its arms angrily in front of an approaching carriage, unaware that they were incapable of stopping it? Such was the high opinion it had of its talents.”
― Zhuangzi, The Complete Works of Chuang Tzu
Turin, Italy, the host nation of the 2006 Winter Olympics. February 17th, the final of the Ladies Snowboard Cross, the first time the event had been staged at the Olympics.
The clear favourite to win the event was US snowboarder, Lindsey Jacobellis. She arrived at Turin as the reigning World Champion in the event.
Jacobellis led right from the start and with the finishing line almost in sight she was cruising to a decisive victory, five seconds ahead of her nearest opponent. Then this happened (the crucial point happens at around 1:20 and you will need to click on the link to open the video in You Tube to view it):
Turns out there’s a fine line between confidence – the state of being sure in your own abilities, which we all need – and overconfidence.
Whilst we can all watch that video and cringe, the truth is we’re all susceptible to overconfidence. In a study carried out by Swedish psychologists in 1980, 93% of the group studied considered themselves to be above-average drivers.
Perhaps nowhere is our tendency for overconfidence more evident that when we are investing. There are several factors at work when we invest which lead to us believing we know better than we do:
– We tend to trust what we know – we are often blinkered about what lies beyond what is familiar to us. It was this trait which led many Enron employees to rely on the company not just for a regular pay cheque but for their financial security for the rest of their lives.
– We overestimate the level of control we have, resulting in a lack of diversification, a tendency to trade too often and to use techniques such as limit orders to validate our belief that we are in control.
– We analyse past events and convince ourselves that we knew what was coming, otherwise known as ‘hindsight bias’. This belief that we could predict what would happen makes us believe that we can just as easily predict the future and means that we do not learn from our mistakes.
– We hate to admit when we’ve made a mistake.
The good news is that you can take steps to protect yourself from these behavioural biases:
– Remember that diversification is your best friend. Although it might mean that there will always be one asset class, or element, of your portfolio which is not doing so well as others, owning a properly diversified portfolio means you are far less likely to suffer a total loss of capital, as can happen when a single company goes under.
– Focus on what you can control. You cannot control markets but by structuring your portfolio to be well diversified across assets which have a positive expected return you can give yourself a good chance of capturing the market returns which are available to everyone. You cannot control the volatility of markets but you can control your costs by seeking out low cost index funds which will reduce the need for excessive trading.
– Keep a ‘Decision journal’. Every time you decide to buy, or sell, a stock or a fund record why. Over time this will either help you to stick to your investment programme as there is a written record of how each trading decision was rationally reached or it will tell you that your emotions and/or the ‘financial noise’ from the media etc. has been driving your investment decisions. Either way, you’ll end up much better informed about exactly what is driving your investment decisions and can make changes if needed.
– Learn from your mistakes. Sorry, no magic potions for this one – it’s up to you
“I have found that the importance of having an investment philosophy — one that is robust and that you can stick with — cannot be overstated.”
—David Booth, Chairman Dimensional Fund Advisors