Tuesday, 11 August 2009

Controlling Your Own Investing Over-Confidence

Question: What’s the difference between God and an actuary?
Answer: God doesn’t think he’s an actuary

This old joke (quote above taken from Making Actuaries Less Human) has appeared with many substitutes for the word actuary. And with good reason because overconfidence in one's abilities, knowledge and judgement is a widespread tendency among humans as academic research (see citings in the above article) have confirmed time and again. Investors are no exception (not even professional investors and analysts) - for proof, read excellent books like Richard Deaves' What Kind of Investor Are You? and Terry Burnham's Mean Markets and Lizard Brains or references on the Overconfidence page of BehaviouralFinance.net.

Investors over-estimate their knowledge, under-estimate risks and exaggerate their ability to control events, including their own reactions. The result is bad decisions that lose money - excessive trading, taking on too much risk, under-diversification, over-estimating possible returns, thinking a bad outcome can't happen, panic selling.

What to do to Control Overconfidence?
Simply saying to yourself "I won't be overconfident" isn't likely to work. Specific techniques are required. Here are some techniques to try:
  1. Find a contrary opinion to your own - read and listen to the argument; as Larry MacDonald's post 11 Trading Tips from Soros relates, legendary billionaire investor George Soros recommends doing this.
  2. Write down the reasons you could be wrong in a pros and cons list for an investing idea
  3. Estimate a range of possible outcomes e.g. stock price, portfolio return, then subtract 25% from low number (the one that will hurt you) as recommended by Gary Belsky and Thomas Gilovich in Why Smart People Make Big Money Mistakes and How to Correct Them.
  4. Set a benchmark or comparator for returns then do a review and ask yourself what you did wrong - bad luck is to be excluded as an explanation since the mistake of thinking "good result = my skill, bad result = bad luck" is the delusion that keeps people from learning and improving as investors
  5. Test the waters with a small pilot investment, then wait to see how it evolves for a while, then invest more only if it shows signs of success (another Soros tip)
  6. Tie yourself down with a strict, numerical set of rules in an investment policy for the funds that are essential to your financial goals and have a separate "money to gamble and lose" pot to indulge your investing macho
  7. Admit you are incorrigibly overconfident and design a totally passive diversified index portfolio and accept the average results that will produce
As the actuaries recognize, we cannot stop being human, we can only take steps to minimize and control overconfidence. At least we can avoid being the cat in the photo "This is going to end in disaster, and you have no one to blame but yourself" from 2FlashGames.com.

1 comment:

Anonymous said...

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