It may sound cliché, but this does not make it less true: becoming a better investor starts with yourself. Benjamin Graham, the founder of value investing and a role model for me, once said that the investor’s chief problem – and even his worst enemy – is likely to be himself. I cannot agree more and hope to convince you of the importance of this wisdom by writing a series of articles about behavioral biases. The first paper in this series is a rather appealing one and I am sure you will recognize many things of this bias in yourself and others. I hope you enjoy reading about the first bias of this series: Overconfidence.
The importance and effects of behavioral biases - #1: Overconfidence
Overconfidence is a very serious problem. If you don’t think it affects you, that’s probably because you’re overconfident. -Carl Richards
I believe we are all, to some extent, prone to behavioral biases. We, -assuming you also have a financial background or at least affinity with the financial sector-, often have a tendency to think we know quite a bit about what stocks to buy and sell and when to do so. This is also what I thought after finishing my master studies and following the financial sector for a few years. Even more so after I saw an enormous raise in stocks' prices that I considered to (but did not) buy in the past. It is this behavior that I have been investigating a lot during the last years. In particular, I had the privilege of doing a large survey for a prominent online broker to investigate the proneness of investors to several behavioral biases and hereafter to examine what the effects of these biases were. This has intrigued me enormously and I would like to share with you some lessons that I have learned and that have also greatly benefited me.
After reading this article I hope that I have made you aware of some common fallacies we are commonly prone to. I will challenge you to make a diagnostic test to evaluate your proneness to overconfidence. Hereafter, I evaluate the test results and give you some advice. Finally, I give an example of a stock that may be overvalued because of behavioral biases.
After decades of extensive research in the psychology field, the importance of behavioral biases has started to become increasingly acknowledged in the (behavioral) finance field. A well-known academic paper which described bias, overconfidence, is “Boys will be boys” from Barber and Odean (2001). Behavioral biases refer to filters where we put our observations through and proneness to such filters may cause substantial investment mistakes. Being unbiased in decision-making is practically impossible. Fortunately, however, behavioral biases can be mitigated with appropriate information provision and by identifying and creating proper investment rules.
Cognition and Emotion
There exist two types of behavioral biases. First, there are cognitive biases, which stem from faulty reasoning. Second, there are emotional biases, which originate from impulse or intuition. Cognitive biases may be overcome with enhanced information provision and advice on how to correct them, whereas emotional biases are more difficult to rectify. Hence, this makes analyzing cognitive biases particularly interesting for financial advisors and therefore I focus on these. Moreover, when advisors focus more keenly on why their clients act like they do, they are in a better position to decide whether behavior need to be modified or adapted to.
Figure 1: The behavior gap between investment return and investor return. (Source: Behaviorgap.com)
Diagnostic Test: How prone are you to Overconfidence?
Before I start explaining about overconfidence, please first consider the below statements and questions. I obviously want to avoid making you biased in answering these questions, and hence you can better answer these questions before reading the full article! At the end of this article, I analyze the test results so that you can help yourself or your clients overcoming this bias.
The scale for the below statements is the following: 1 totally disagree; 2 disagree; 3 neutral; 4 agree; and 5 totally agree:
S1) My investment skills are above average. (1 – 5)
S2) I believe to have control in picking stocks that will outperform the market. (1 – 5)
S3) The collapse of the stock market in 2008 could be anticipated easily. (1 – 5)
Q1) Give high and low estimates for the daily circulation of the Financial Times (print sales) so that you are 95% certain that you are correct.
Q2) Give high and low estimates for the return on the S&P 500 index over the next 12 months so that you are 95% certain that you are correct.
In its basic form, overconfidence can be described as unfounded faith in one’s judgments and cognitive abilities. It occurs when people have a tendency to think that they are better than they truly are and/or have a tendency to assign too tight confidence intervals for uncertain events.
An example of the latter is that after a tip from someone or after some reads on the internet, many investor feel ready to take action and make an investment based on their perceived knowledge advantage. Various studies show that investors are overconfident in their investment abilities (See Deaves et al., 2009; Barber and Odean, 2001; Odean, 1998).
Male investors are generally found to be more likely to perceive themselves as knowledgeable or skillful than females (Graham et al., 2009). As a result, while both men and women exhibit overconfidence, men are generally more overconfident, especially in tasks pertaining to the masculine domain such as investing (Beyer and Bodwen, 1997; Lundeberg et al., 1994). Consistent with these findings, Barber and Odean (2001) use trading frequency as a proxy for overconfidence and show in their investigation, including approximately 35,000 households, that men trade 45% more than women, and excessive trading reduces their net returns by 2.65% per year as opposed to 1.72% for women.
Furthermore, young investors are expected to be more overconfident, especially highly educated ones (Heath and Tversky, 1991). This may be because with more experience, self-assessment becomes more realistic and overconfidence more subdued.
Besides excessive trading and an underestimation of the associated risks of active stock investing (Kyle and Wang, 1997), overconfidence can result in (1) a neglect of negative information that should normally indicate that an investment asset should be sold, (2) an underestimation of downside risk, and (3) in holding undiversified portfolios (Goetzmann and Kumar, 2008).
Analysis Test Results
S1) Obviously, respondents who belief that they are an above-average investor are likely to be prone to overconfidence. Fortunately, there is a group that is able to yield above average investment results. It appears, however, that many investors belief that they are better than other investors, however very few, including institutional investors, perform actually better than the market over a large period of time.
S2) Respondents who feel that they have control in picking stocks that outperform the market are likely to be prone to overconfidence. Large hedge funds who spend millions in trying to find stocks that outperform the market often fail to do so over a large period of time. Do you consider yourself better than these investors? Several studies show that there are very few who truly possess stock selection ability.
S3) Respondents who indicated that the stock market crash in 2008 could be easily anticipated are likely to be prone to overconfidence. Obviously, with hindsight, there were many signs that told us that a market crash was nearby. This is however with hindsight. At that moment of time, investors had only seen the market go up for many years, and this tends to make people forget about the risk of a crash. After all, only very few profited from the collapse by going short big time.
Q1) The actual circulation of the Financial times was reported to be about 210 thousand copies in 2014. If you specified a too restrictive interval (e.g. 100 to 200 thousand) you are likely to be prone to prediction overconfidence. Moreover, given the well-known name of this journal, if you assigned a way too high interval (with the low estimate far exceeding the actual number), you are also likely to be prone to certainty overconfidence.
Q2) The arithmetic average return of the S&P 500 index is 11.45%. This has however been achieved with very volatile returns with a low of -36.55% in 2008 and a high of 43.7% in 1958. A range of somewhere between -25% to -30% up to +35% to +40% would probably be an interval providing sufficient comfort. If you gave a (much) narrower interval, you are likely to be prone to prediction overconfidence.
Generally it is important to:
1) Acknowledge the importance of behavioral biases;
2) Acknowledge that you may be prone to several behavioral biases;
3) Mitigate the effects of your proneness to behavioral biases by creating proper investment rules and evaluate your investment behavior regularly.
For overconfidence specifically:
1) Only believe in having stock selection ability and/or market timing ability after showing to possess this over a large period of time. If the conclusion is that you do not have it, you can choose not to invest in individual stocks at all. There exist many low-cost strategies that give you exposure to a large percentage of the stock market with only a few trades (e.g. the MSCI World Index). If this eradicates your passion for investing, you may think of a 90/10 division, i.e. 90% for long term return and 10% for ‘fun’, with some individual stock picks. Be sure to rebalance regularly though.
2) Less is more: excessive trading will most probably only cost you money;
3) Diversify, diversify, diversify. Do not bet all your money on only a few stocks, being wrong may be more likely than you think it is.
A final example of overconfidence in a current ‘hot stock’
Before ending this first article, I would like to give some attention to a popular stock that has been discussed earlier on Foresight Investor.
Tesla is an extreme example of a growth stock, i.e. a stock where the current valuation is based on the promise to deliver in the future. It has a market cap of about $28B, about half the market cap of GM. Not bad for a company who has only incurred losses so far right? Can this be in part explained by overconfidence?
As a gentle reminder, we as investors tend to be very creative in valuations. Mainly due to herd mentality, financial assets tend to behave opposite to other goods, i.e. demand tends to increase when financial assets rise in price. To the extent that we care about valuations, we tend to be highly flexible. Future profits and thus cash flows can always be adjusted a bit higher to justify the price. And if we do not feel comfortable with increasing our expectations any further, then we can still come up with some alternative valuation metrics right?
For example, Facebook recently paid $42 “per WhatsApp user” (or $344 million per FTE). Is this truly rationally justified? See some other examples below.
Figure 3: The social costs of various innovative communication companies. (Source: Reuters)
Does this also remind you of the recent internet bubble with “price-to-click” valuations?
Back to Tesla, if you are one of the many investors owning the stock or consider buying it, then ask yourself: is the current value justified? If yes, why? Is this based on proper research or does your “gut feeling” or “intuition” tell you it is a good investment?
The latter may by the way be an indication of overconfidence by itself, e.g. a “gut feeling” is generally based on irrational arguments and/or a hype and underlines one’s inability to explain why he/she feels in such a way. Do not let overconfidence trick you regarding such growth stocks; most probably you do not have better information than others. Many studies show that value stocks (the boring ones) perform better than growth stocks. If you want to play lottery, then I suggest you to go to the casino.
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Bart is our behavioral finance expert. He beliefs that investing starts with knowing yourself and your surrounding.