Behavioral finance is the application of psychology to financial behavior, especially the study of why people sometimes act irrationally with respect to their finances.  One of the most common of these mental errors is a tendency toward overconfidence.  People appear to honestly and consistently overestimate their ability.  This leads to mistakes including insufficient diversification (which increases risk) and overtrading (which increases costs).  Men are more prone to this than women and professionals (especially investment professionals) are more susceptible than others.  While there are numerous studies on this, the following is an excerpt (with minor editing and abridgement) from a classic article (1999) by Whitney Tilson:

In general, an abundance of confidence is a wonderful thing. It gives us higher motivation, persistence, energy and optimism, and can allow us to accomplish things that we otherwise might not have even undertaken. Confidence also contributes a great deal to happiness.

But humans are not just robustly confident-they are wildly overconfident. Consider the following:

  • 82% of people say they are in the top 30% of safe drivers;

  • 86% of my Harvard Business School classmates say they are better looking than their classmates (would you expect anything less from Harvard graduates?);

  • 68% of lawyers in civil cases believe that their side will prevail;

  • 81% of new business owners think their business has at least a 70% chance of success, but only 39% think any business like theirs would be likely to succeed;

  • Graduate students were asked to estimate the time it would take them to finish their thesis under three scenarios: best case, expected, and worst case. The average guesses were 27.4 days, 33.9 days, and 48.6 days, respectively. The actual average turned out to be 55.5 days.

Importantly, it turns out that the more difficult the question/task (such as predicting the future of a company or the price of a stock), the greater the degree of overconfidence. And professional investors – so-called “experts” – are generally even more prone to overconfidence than novices because they have theories and models that they tend to overweight.

Perhaps more surprising than the degree of overconfidence itself is that overconfidence doesn’t seem to decline over time. After all, one would think that experience would lead people to become more realistic about their capabilities, especially in an area such as investing, where results can be calculated precisely. Part of the explanation is that people often forget failures and, even if they don’t, tend to focus primarily on the future, not the past. But the main reason is that people generally remember failures very differently from successes. Successes were due to one’s own wisdom and ability, while failures were due to forces beyond one’s control. Thus, people believe that with a little better luck or fine-tuning, the outcome will be much better next time.

So people are overconfident. So what? If healthy confidence is good, why isn’t overconfidence better? In some areas – say, being a world-class athlete – overconfidence in fact might be beneficial. But when it comes to financial matters, it most certainly is not. Overconfidence often leads people to:

  1. Be badly prepared for the future. For example, 83% of parents with children under 18 said that they have a financial plan and 75% expressed confidence about their long-term financial well being. Yet fewer than half of these people were saving for their children’s education and fewer than 10% had financial plans that addressed basic issues such as investments, budgeting, insurance, savings, wills, etc.

  2. Trade stocks excessively. In Odean and Barber’s landmark study of 78,000 individual investors’ accounts at a large discount brokerage from 1991-1996, the average annual turnover was 80% (slightly less than the 84% average for mutual funds).

  3. Believe they can be above-average stock pickers, when there is little evidence to support this belief. The study cited above showed that, after trading costs (but before taxes), the average investor underperformed the market by approximately two percentage points per year.

  4. Believe they can pick mutual funds that will deliver superior future performance. The market-trailing performance of the average mutual fund is proof that most people fail in this endeavor. Worse yet, investors tend to trade in and out of mutual funds at the worst possible time as they chase performance.

  5. Have insufficiently diversified investment portfolios.

[M]y observation [is] that people who go into [investing] tend to have a very high degree of confidence. Yet ironically, it is precisely the opposite – a great deal of humility – that is the key to investment success.

Back to David: You may be wondering why I decided to share that when there seem to be much bigger issues right now. After all, stocks are down, bonds are down, inflation is up, and things look scary to many, if not most, people. You may have (justifiably) expected at least a little market commentary this month.

I share this because I think he left a very important item out of his five effects of overconfidence. So, let me add it:

  1. Believe they know better than the collective wisdom of the market what the “correct” prices are.

Now, on very rare occasions, I think that belief may be true, (I think it was possible to recognize tech stocks in 1999 and real estate in 2007 as mispriced, for example) but it isn’t generally true. If you think you know what the market will do next, that means you think the rest of the market participants have it wrong. You may be right, but it is more likely to be simple overconfidence in your opinion.

Also, when you feel extreme pessimism or optimism other people probably feel the exact same way which means the market is likely to be very near the bottom or top. Of course, people can get more pessimistic (or optimistic) so the market can continue down (or up), but the more strongly you feel, assuming others feel the same way, the more likely it is that it is exactly the wrong time to act on that feeling.

The market doesn’t move on things being good or bad, it moves on things being better or worse than expected and if everyone expects disaster already, it can’t very well go down much.

I’ve used the pronoun “you” in the previous paragraphs, but it’s all of us. I expend a lot of emotional and mental energy trying to stay as dispassionate as possible – your financial advisors have feelings too! – but I know that acting on my feelings is almost certainly not going to lead to the best outcomes (on average) for our clients. It’s why I stay immersed in the behavioral finance literature. It isn’t to recognize client misbehaviors (well, not primarily), it’s to recognize when I am likely to make a mental mistake!

Now, having said all that, I’m actually pretty sanguine about markets right now. They don’t seem all that scary or mispriced to me. I’ll close with something I wrote to our clients recently:

There are things that could cause the market to crash – full scale war with China, for example – but there are always things that could cause the market to crash, and, as Peter Lynch observed, “Far more money has been lost by investors preparing for corrections or trying to anticipate corrections than has been lost in corrections themselves.”

In summary, you should sleep soundly – I will!

While Financial Foundations is intended primarily for our clients, we are happy to expand our readership so feel free to pass this along.

We have clients nationwide; if you know someone we may be able to help with their financial planning and wealth management, we would be happy to have a conversation. Please feel free to pass along our contact information.

Regards,
David

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