Investor Overconfidence Revisited

According to Dalbar, a financial analytics firm, the average stock investor had an annual return of 3.83% from 1990 to 2010.

Over that same time frame the S&P 500 had a return of 9.14%.

A 5.31% gap.

This more recent report by the same firm showed a somewhat narrower gap but, not surprisingly, what otherwise was a similar result.

Why Your Investment Returns Could Be Lower Than You Think

This unfortunate outcome is consistent with what their earlier reports have shown.

Though a factor, it's not just high fees that account for the difference.

It's also not necessarily due to poor average mutual fund performance.

A bunch of the gap comes down to investor behavior. For example, buying when the world seems more certain* and the outlook appears to be the rosiest. Selling when it is less so. This pattern tends to result in buying assets when they're not cheap (or worse, rather expensive) and selling when the opposite is true.

That's a tough way to achieve even satisfactory results as an investor.
(Never mind very good results.)

It also results in unnecessary mistakes -- some of which are related to the Illusion of Control -- while incurring additional and unnecessary frictional costs. Some might expect that market participants would be becoming more aware of this pattern of behavior by now then make the necessary adjustments. Maybe behavior is slowly changing and it just isn't yet being reflected in the numbers. If not, then apparently too many still conclude that it only applies to the other guy.

Basically, investors are generally way more confident in their investment skills than they should be.

Lake Wobegon is the fictional town where "all the children are above average." Well, this article from The Motley Fool mentions the Lake Wobegon effect as it applies to drivers.

Fighting Investors' Greatest Enemy: Overconfidence

It turns out that the vast majority of drivers think they are above average. Those that don't consider themselves better than average being more the exception.

Amazingly, as the article points out, this optimistic self-appraisal persists even when the survey is done of drivers that have just caused an accident serious enough to put them in a hospital.

Charlie Munger has previously referred to a study of Swedish drivers to make a similar point.**

Overconfidence is a dangerous thing for a driver. The same, of course, is true for an investor.

It gets worse. Not only do they tend to believe they outperform the average investor, they overestimate their actual returns. In other words, investors convince themselves they've performed better than they have when a careful look at actual results would reveal otherwise.

From The Motley Fool article:

...researchers asked investors to estimate their annual returns, and then compared those estimates to the investors' actual returns by checking their brokerage statements. Investors were quite literally clueless about how their investments performed, overestimating their returns by more than 11 percentage points per year. The average investor painfully lags an index fund and thinks he's Warren Buffett, basically.

According to Jason Zweig, one explanation for this tendency comes down to "positive illusions" that may serve to boost self-esteem.

"By fibbing ourselves, we can give a needed boost to our self-esteem."

If results aren't great, and lots of effort has been expended, I guess it's easier to just ignore the reality.

Another explanation comes from hindsight bias that leads to too much confidence in forecasts and predictions. The following Daniel Kahneman quote is used in the same article to further explain:

"Our tendency to construct and believe coherent narratives of the past makes it difficult for us to accept the limits of our forecasting ability. The illusion that we understand the past fosters overconfidence in our ability to predict the future."

Not surprisingly, it turns out the most confident forecasters are the worst forecasters.

Excessive confidence leads to a reduction in perceived risk but, of course, not the actual risk.

Think Long-Term Capital Management (LTCM).

LTCM might be the best example among many of what happens when high IQ meets overconfidence.
(As an aside: Could there be any more perfect name for an entity that couldn't survive beyond just over 4 years?)

Charlie Munger on LTCM & Overconfidence

Charlie Munger once said: "If you totally divorce economics from psychology, you've gone a long way toward divorcing it from reality."

Well, it seems clear that the same can be said about investing.

Munger also added this about the importance of knowing the edge of one's own competency:

"Warren and I have skills that could easily be taught to other people. One skill is knowing the edge of your own competency. It's not a competency if you don't know the edge of it. And Warren and I are better at tuning out the standard stupidities. We've left a lot of more talented and diligent people in the dust, just by working hard at eliminating standard error."

Investor overconfidence isn't easy to combat but it starts with an awareness of limits and respect for the psychological factors that reinforce it.

Warren Buffett explained it this way in the 1999 Berkshire Hathaway (BRKa) Shareholder Letter:

"If we have a strength, it is in recognizing when we are operating well within our circle of competence and when we are approaching the perimeter."

More think they know the edge of their competency than actually do. Being vaguely familiar isn't enough. It's truly knowing one's own circle of competence, staying well within that circle, while learning to appreciate the various, sometimes subtle, cognitive illusions and biases that get investors into trouble.

Some will no doubt conclude that it's not terribly important to seriously consider the psychological factors that contribute to lower returns and greater than necessary risk-taking.

They'll decide it somehow doesn't really apply to them.

Those same investors might then, as a result, decide the psychological stuff deserves nothing more than a passing glance.

That's a mistake.

Adam

Long position in BRKb established at much lower than recent market prices

Related posts:
Investor Overconfidence
Investors are Often Their Own Worst Enemy, Part II
Investors are Often Their Own Worst Enemy
The Illusion of Skill
The Illusion of Control
Charlie Munger on LTCM & Overconfidence
When Genius Failed...Again

* I say "seems more certain" because the world is effectively always uncertain even when it doesn't seem to be. Mostly, it is just the perception of certainty that changes. Big surprises should be considered inevitable 

but there's nothing new about that for investors.
** Charlie Munger speaking to Foundation Financial Officers in 1998: "...a careful survey in Sweden showed that 90% of automobile drivers considered themselves above average. And people who are successfully selling something, as investment counselors do, make Swedish drivers sound like depressives. Virtually every investment expert's public assessment is that he is above average, no matter what is the evidence to the contrary."
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Investor Overconfidence Revisited
Investor Overconfidence Revisited
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