Overconfidence and how to fix it

Have you ever marvelled at the conviction a stock market guru or company manager's exhibit in interviews?

They spout stuff like ‘Indian GDP will grow X per cent' or ‘the company will grow by Y per cent'. Headlines scream : ‘Confidence in Euro bailout sends markets up' and ‘Euro debt worries send markets crashing'. An understanding of the ‘overconfidence bias' concept will prevent investors from getting swept away by these statements.

We all overestimate our knowledge, skill or virtue. As Malcom Gladwell writes in a New Yorker article, “One of the things that happen to us when we become overconfident is that we start to blur the line between the kind of things that we can control and the kind of things that we can't.”

DISTURBING FINDINGS

Research on American investors, particularly men holding discount brokerage accounts, reveals what overconfidence does to returns. The decade old study indicates that investors, particularly ones proffering to be very confident or with high conviction, tend to trade a lot more! Their increased trading did not produce returns.

On the contrary, they lowered returns which were to be had by staying still. Similar studies have shown that academics, students, econometric practitioners all tend to underperform relative to their perceived ability to forecast accurately or confidence to conduct research.

We tend to pump up our ego not just to boost our self-esteem but also feel more optimistic about approaching a task or taking a decision. Imagine what would happen if a professional athlete thought before a game that he was doomed. Or a student taking a test. Chances are they will mess it up.

Investing is neither a game nor an examination to be taken. A loss resulting from bad decisions is capital lost. The early humans may have worked up a frenzy to throw a spear a mammoth, but that kind of confidence does no good to an investor trying to choose a particular investment.

DANGEROUS METHOD

Of course, mutual funds put out a disclaimer that past performance is not guarantee of future results. We've all sped through such disclaimers. Intuitively, that is a point we grasp quite well: No one invests money in a mutual fund without asking how the returns have been or which fund house is behind the product.

But here is a corollary: A string of successes tends to increase overconfidence levels and vice versa. Time and again, investors have grown complacent in bull markets much and fearful in bear markets. In bull markets they believe their due diligence is comprehensive and their investments secure. This is until markets pull the rug from under them.

SAME OLD SOLUTION

In a complex setting such as equity, bond or real estate markets, confidence often fosters a blind spot. In the delightful words of psychologist Ellen Langer (through Gladwell), “...This is what competition does to all of us; because ability makes a difference in competitions of skill, we make the mistake of thinking that it must also make a difference in competitions of pure chance.”

Here are a few common mistakes and quick fixes for mistakes stemming from overconfidence:

Your experience either tells you that ‘This time its different' or ‘I've seen this before' and you make a bet based on this. Avoid this tendency. Your decisions should be made based on reason.

My buy price was 20 per cent higher, so I am confident it's a buy now! Again avoid decisions made on such gut feeling. Buy because you've weighed the reasons which pushed prices down by 20 per cent and then take a call. Maintaining a log of why investment decisions were made helps your cause.

You've done a lot of homework on a mutual fund or stock you want to pick. Quickly run it by a few fellow-investors. If you have a blind spot, chances are someone could help you spot it.

Especially relevant for fundamental investors: You arrive at a price which you think an asset is worth. Apply a generous discount to that before buying. Benjamin Graham called it Margin of Safety. It is your safety net.

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