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The overconfidence effect and investing

Basketball - Nothing but netA couple of years ago, my friends called me up. Like good friends do, they told me that I was nominated to be on their basketball team — which they had signed up for at the local community center. It’s not that I’m the worst to ever play the game, but I was shocked to be included… even in a rec league. I agreed, knowing that our success was not dependent on my ability. I had confidence in my friends who played at the time far more than myself. I can honestly say that, until that first game, I have never quit on a team that I was part of; no matter how bad it got, I was loyal to the end. However, that first night we played, I found my limit — the result of the overconfidence effect.

If I can paint a picture for you: I walked into the gym wearing my American Flag Converse All-Stars and the first thing I saw was grown men jumping from the free-throw line and dunking the ball with unbridled fury, as if the ball had personally offended them.  That first game we lost at the buzzer: 25 – 92. Well, I don’t remember the actual score, but I know the other team was divisible by ours multiple times over.

I walked in biased with overconfidence because of my knowledge of my teammates and their athletic ability, at least within our circle. True, our team was made up of naturally athletic people along with some that played at the college level. But in retrospect, the sports of soccer, golf, and tennis don’t translate to something greater than the skill of those who have played basketball at a higher level.

What is the overconfidence effect?

This happens within our investment portfolios as well. We can have what is called a behavioral bias of overconfidence, which is also known as the “overconfidence effect.” This is where we feel the information or ability we possess has value beyond the metrics, and it’s a well-established phenomenon. An example of this would be how someone may feel about the stock of the company they work for. Because this person has their hand on the pulse of the inner workings, they feel they may have more visibility than they actually do. This attitude often leads to a false sense of security, and subsequently becoming overweight in that position. The same can happen when one feels nostalgia for an investment position that was gifted, perhaps by parents or grandparents. This could be thought of as an “it worked for them and so it’ll be the same for us” type of mentality.

Where investing overconfidence comes from

Overconfidence in investments can come from many different sources, such as stores we shop at, items our kids are into, or even industries to which our work lead us. An example might be the thought that many of us have had at some point. Have you ever said to yourself “I use this product so much I should buy stock in it”? This is not to say that we won’t discover a hidden gem, or that we shouldn’t be on the lookout for new investment opportunities. But investment and retirement plans should be exactly that: plans. What is the purpose of the investment, and how is it complimenting your overall portfolio — as compared to how you “feel” about it?

HandcuffsThe other side of the overconfidence effect: pessimism

Overconfidence can also lend itself to the pessimist. That’s especially true in times like today during the coronavirus epidemic and its economic impacts. The market has pulled back and is difficult to assess; those who are pessimistic often become even more entrenched in their beliefs. This can be further confirmed by a well-written article, perhaps in one’s favorite financial periodical that also believes “the worst is yet to come.” It’s not to say that more dips will not happen in the market, but what is the likelihood that you will be able to time them appropriately? It is very reasonable to believe that a longstanding pessimism of the market, coupled with inaction, could lead to walking past years of gains.

How to fight the overconfidence effect when you invest

Think Outside the BoxThe fix to overconfidence is to create a plan, one that is based on a framework of risk that is acceptable — and emotionally manageable.  Pay attention to your weights in different markets and spaces, and allow diversification to be your friend. The adage of Warren Buffet still applies: If you are not willing to own a stock for 10 years, do not even think about owning it for 10 minutes.”  Build your portfolio on what is a value and purposeful.

To those who are more sensitive to risk (or self-declared pessimists!) figure out what you’re willing to put to risk, and what you would like to store as “dry powder.”  Have dates and market values at which you’re committed to investing (i.e., if the market goes down X or if the market sustains X level.) Putting money to work overtime — either through contributions or dollar cost averaging — is a conservative approach to buying into the market, without bringing in emotion.

Remember, if you need help or have any questions I am here to serve.

Content in this material is for general information only and not intended to provide specific advice or recommendations for any individual. No strategy assures success or protects against loss. Investing involves risk including loss of principal. There is no guarantee that a diversified portfolio will enhance overall returns or outperform a non-diversified portfolio. Diversification does not protect against market risk.

 

May 2020

 

 

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