While growing up, if a group of our friends were forming a cricket team and the question was put, “Who wants to lead?”, all 11 hands would go up. We firmly believe we are perfect employees, perfect citizens, perfect parents, perfect spouses, perfect drivers, and, of course, perfect investors. But how can someone be perfect in all aspects? Welcome to a deadly emotional bias that has led to the downfall of great empires, “too big to fail” companies, artists and investment portfolios—overconfidence.
“Experts” run the risk of turning into astrologers. As Rolf Dobelli, the author of The Art of Thinking Clearly, writes, we comment on stock market forecasts, the direction of interest rates, or firms’ profits in the next one to three years with a fair amount of overconfidence. We systematically overestimate our ability to predict, and the reach of our knowledge, on a massive scale. Often, experts fall prey to overconfidence more than the layperson.
Know what you don’t know: The “overconfidence bias” is a tendency to hold a false and misleading assessment of one’s skills, intellect, or talent. It originates from an illusion of knowledge. Highly-qualified teams involved in robust research studies sometimes create an illusion of superiority and control to outsmart the market.
“I try to get rid of people who always confidently answer questions about which they don’t have any real knowledge. To me, they’re like the bee dancing its incoherent dance. They’re just screwing up the hive,” says Charlie Munger, vice-chairman, Berkshire Hathaway.
Lucky outcomes can also lead to overconfidence. With a few back-to-back wins, the gambler starts believing that he is led to favourable outcomes because of his skills. Complacency also makes us overconfident.
Many invest when past returns have been high, not realizing that at that juncture, it’s the risk that’s high, not return potential. Good investors look for reasons for outperformance or high performance, understand the investment framework, question whether the cycle will turn and then take an investment decision.
Respect variables: Investors like high-conviction advice from “experts” that the Nifty will cross 25,000; or that 10-year bond yields will rise to 9%. Some will not only forward these messages to friends, but also invest money based on such overconfidence. Instead, track how past predictions, made with “confidence”, have underperformed. Investing and economics are not like math or physics, which are fields of exact science that run on a defined formula. In investing, there are many moving parts and non-stationary data. Research results in part-information, which is sometimes imperfect.
How to resist the temptation of being overconfident with money: First, let’s acknowledge that being a good engineer, or a doctor, a lawyer or a data scientist, or a teacher doesn’t guarantee us a ticket to be among the best investors. Start with this acknowledgment and work with a good expert to help you with investment decisions.
I keep repeating this input of seeking advice, as investing is serious business and good advice can go a long way in curbing our behavioural errors and coaching us to become better investors, over time. Second, while forming confident views of the future, also evaluate what can go wrong if the view doesn’t play out. What can the downside be?
Doubt extreme views and exaggerated returns: For example, when the return-on-equity of Indian companies varies from 10% to 20% across cycles, and you are promised 20-25% returns on the basis of just the past three years, be sceptical. When interest rates average 8% in India, and you expect to earn 10% in bond funds just because last year it was 12%, raise doubts. Wise, good advisers and money managers will never be overconfident. They are more often in doubt, constantly thinking about what can go wrong as much as what will work out fine. They will always have answers in a range with probabilities of various good and bad returns. They will prepare you for some pain, rather than pull you to invest on the basis of guaranteed results.
If you have formed a view of investing based on a hypothesis, do mull over an opposite view. This will help you get a balanced perspective for decision-making and avoid losses due to a one-sided, overconfident view.
Last, learn from history. Read more about what failed in investing and why. Be objective, rational, evidence-based. Become an above-average investor by being less overconfident.
Kalpen Parekh is president, DSP Investment Managers.
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