The Biased Investor (Part 2)
How confident are you?
Photo: Rhett Sutphin. Source: Wikipedia
We like optimistic people. They encourage us and help us to overcome obstacles. The author “Zig” Ziglar was once told, when checking in at the airport, that his flight had been delayed by three or four hours. “Fantastic!” was his reply. Puzzled, the check-in clerk asked how Zig could be so happy when he just had his plans disrupted. “I now have three hours to relax and enjoy myself,” he told the clerk.
But there is a line between optimism and presumption, between boldness and hubris. Overconfidence can lead us to do foolish things. Consider sports competitions: almost every team starts the season with the belief that they will end the year with a winning record. But by definition, only half the teams will do so. And only one can be the champ. Still, it’s important have a positive perspective. Otherwise, why bother training? A negative outlook can become self-fulfilling.
There are two aspects to knowledge: what we know, and how certain we are of what we know. If you tell me there should be a convenient parking spot available when we are driving downtown, you might be 50%, 80%, or 100% certain of that knowledge—especially if you know whether or not the legislature is in session. It’s easy to check whether the statement was accurate, after the fact. But it’s a lot harder to judge the confidence interval. When it comes to investing, the degree of confidence matters.
Photo: Christophe Michot. Source: Wikipedia
When people examine their investment results, they are often surprised by what they see. Overconfidence causes us to focus on the winners in our portfolios, rather than look at the entire picture. It’s what leads investors to pile into overpriced stocks when the market is rising. Our confidence rises when we get more information, whether or not that information is relevant to the investment process.
Overconfident investors tend to trade more and they are attracted to more speculative issues. When you trade, you’re making two decisions: one on what you’re selling, and one on what you’re buying. It’s tempting to dump your losers and go into hot issues, but often, that means selling stocks that are cheap and buying those that are dear—selling low and buying high.
We don’t know the future. We can calculate the odds, but often, new news stirs the pot and makes everything murky. It’s good to be optimistic; but even Zig Ziglar can have a bad day.
Douglas R. Tengdin, CFA
Chief Investment Officer