Tuesday, 29 December 2009

How to Fix Overconfidence, the Worst Investing Attitude Problem

Corralling and correcting one's own behaviour avoids investing disappointment and leads to financial success.

The Overconfidence Problem
Believing oneself to be an expert when one is not, or thinking that one knows the outcome when one does not, is said to be the most common and costly fault of investors. Overconfidence manifests itself through excessive trading, over-extended bull markets and speculative bubbles as research summarized on Behavioural Finance tells us. Overconfidence is not a problem of stupidity - intelligent people are no more or less susceptible than others. Men investors are apparently more prone to overconfidence than women (according to a famous study by Barber and Odean, who are men, it might be noted)! So are highly educated people and professionals like engineers, doctors and lawyers (so says Richard Deaves in his book What Kind of Investor Are You?). The underlying causes of overconfidence: a) too much trust in one's intuition and b) taking the shortcut of looking for and finding patterns, which are sometimes real, sometimes imaginary, and then thinking without questioning that they will continue or be repeated. If you say, "not me, I'm not overconfident", try this amusing little test from Tim Richardson.

1) Feedback - Learning from experience was found to lessen overconfidence by Russo and Schoemaker in Managing Overconfidence. Learning only happens when there is feedback so that a person compares original assumptions and logic against what actually happened. An investor should compare expected vs actual results and ask why they are different. An annual portfolio checkup is one possible occasion to do this. Any buy or sell point is another opportunity. It is important to write things down to avoid mis-remembering things, as we are woefully prone to do (see Rosy retrospection error in previous post Five Common Investor Judgement Errors and How to Counter Them)

2) Counter-arguments - Seek the contrary viewpoint to your own before taking action. Look at whatever free research your online broker provides on a company. Search online investment forums like Financial Webring, OnlineTradersForum, Motley Fool, Canadian Business and post a question. If you are a man, ask a woman, you may well get a valuable alternate viewpoint.

3) Awareness - Merely being told that overconfidence is a danger apparently helps according, again, to Russo and Schoemaker. As the hoary expression goes, recognizing that there is a problem is the first step towards a solution. Consider yourself told.

4) Homework - A source of the gap between what people believe about their own ability and the reality of their ability is whether or not work has gone into a decision. Thus, you may ask yourself "have I worked hard at getting and checking my decision and have I done all that I can?" The more work you do, the less overconfident you become and the better the decision in terms of outcome. If an investment looks easy or obvious, you should worry that you over-looked something. You should be able to list pros and cons. You will improve the odds that Larry Kersten's witticism refers to - "Overconfidence - Before you attempt to beat the odds, be sure you could survive the odds beating you.

In investing terms, survival is short and long term. Big and small investments both count. Repeated small investing losses that are not each individually disastrous, can add up to big losses and that is often what happens. Taking steps to control overconfidence brings one closer to a proper level of confidence.

Disclaimer: this post is my opinion only and should not be construed as investment advice or recommendations.

1 comment:

Michael James said...

I'm not sure what it says about me, but I got two wrong on Tim Richardson's test. I'd say that overconfidence is neck-and-neck with fear as the worst investing attitude problem.