Published On: June 16, 2020
Written by: Ben Atwater and Matt Malick
Today, we continue our series on behavioral finance. This is an extremely important time to look at behavioral finance because of the overwhelming emotion of 2020, as we struggle with COVID-19 and its impact – social isolation, anxiety, depression, economic destruction, racial tension, erratic markets, etc.
Behavioral finance is the crossroads of psychology and economics. It recognizes that investors are not always rational, have limits to their self-control and have biases that influence their decision-making. With this series, we hope to explain the phenomenon and illuminate it with examples from our experiences.
In our first essay, we gave a broad overview of four general classifications of decision-making biases – self-deception, heuristic simplification, emotional bias, and social influence. Now, we will delve deeper into the concept of overconfidence, which falls in the category of self-deception.
We can best explain overconfidence using a George Carlin joke. Carlin said that anyone driving faster than you on the highway is a “maniac” and anyone driving slower than you is an “idiot.”
In other words, we all tend to think we are above average, whether driving or investing. This overconfidence can lead us to taking on too much risk.
We can arrive at this overconfidence by adopting an illusion of control. As an example, the worst investment we ever made was the stock we researched the most.
Years ago, we acquired what we knew was a risky asset, but by researching it inside and out, including conversations with company management, we felt we knew the company so well that although the investment was risky, we should nonetheless acquire it. Our exhaustive work and knowledge gave us an illusion of control.
Purchasing something that you think is a great value naturally leads you to think you will realize that value relatively quickly. Or in behavioral finance jargon, timing optimism means your overconfidence leads you to believe you will make a quick profit.
The adage “it is not about timing the market, rather it is time in the market” has been true on a historical basis, but people still tend to think markets (or individual investments) should only go up during their holding period.
Embracing, instead of lamenting, “bad timing” is a true advantage in the context of a disciplined investment strategy. As it relates to the broader markets, too often people give up if the initial timing is off. Interestingly, when it comes to an individual security, the behavioral tendency is the opposite – people tend to hang-on too long.
Nobody makes an investment thinking it is going to be lousy. So, when you make an investment, you think it will be a success. There is an element of wishful thinking or a desirability effect. Simply because we want the outcome to be positive, we assume it will be.
Repeated anecdotes about today’s markets indicate there are too many individual investors in the market playing the hot stock, quick profit game. This will undoubtedly lead to meaningful and permanent losses for most of these speculators.
A good corrective measure to overconfidence is to train your mind to fear being wrong. This comes naturally with our skeptical nature, but even given our predisposition, it is easy to assume that our research and rationale will work. Keys to hedging against overconfidence include responsible spending; robust savings; anticipating and accepting setbacks; thinking long-term (10 to 50 years depending on your age); and a disciplined and systematic investment process.