Investors have a love / hate relationship with confidence. On one hand, being confident in your analysis, process, and team is critical to making sound and successful decisions. On the other hand, overconfidence, especially to the point of hubris will lead to risk taking, which can ultimately lead to losses that become insurmountable.
The word hubris finds its root in the Greek work hybris. In ancient Greece, hybris referred to actions of those who challenged the gods or their laws, which led to their eventual downfall. In fact, hybris was considered the greatest sin of the ancient Greek world. The story of Icarus is one of the most telling examples of hybris in ancient Greek mythology. Despite repeated warnings from his father Deadalus, Icarus was overcome with the giddiness of being able to fly and flew to close to the sun. He burnt his feathers, was no longer able to fly, and fell into the sea.
In investing it is critical to be aware of overconfidence and protect against the development of hubris, particularly after a recent period of success in the markets. This success can lead to, naturally, a feeling of overconfidence and more rampant risk taking. This psychology predicament is well known in many fields. In the military, this is referred to as “victory disease” as successful military commanders have a tendency to demonstrate poor judgment after a series of military victories. Napolean’s ill fated invasion of Russia is, perhaps, one of the more notable examples.
From an investment perspective, overconfidence creates at least three fatal flaws: miscalibration, better than average effect, and illusion of control.
- Miscalibration occurs when investors overestimate the precision of their knowledge and tend to use confidence intervals that are too narrow. In a paper by Graham and Harvey, CFOs were given a multi-year survey and asked to give their 80 percent confidence interval for stock market close over the next year. When over 4,300 forecasts were measured against the actually results, only 30.5 percent, or less than a third, were accurate within the 80 percent confidence interval.
- Better than average effect occurs when people grossly misjudge their abilities. This was highlighted in a recent Washington Post poll in which, “94 percent of Americans said they were above average in honesty, 89% in common sense, 86 percent in intelligence, and 79 percent in looks.”
- Illusion of control involves the belief that one may be able to influence random events. In a famous study by Langer and Roth, participants were asked to flip a coin ten times with rigged results. When asked how they would do in a game of 100 flips, those who started with a series of wins expected to do much better and, additionally, almost forty percent believed they would get better with practice.
Overconfidence is much more than just a behavioral economic trait that we need to be aware of it, it also has an actually physiological foundation in the way of dopamine, which is a chemical that the body generates to reward “success” and by creating a feeling of pleasure. Keith has previously posted on the impact of dopamine and Richard Peterson summarizes this effect well in his book “Inside the Investor’s Brain”:
“The dopamine-based reward learning process encodes a profitable pattern of behavior. Subsequently, however, highly profitable traders may have difficulty maintaining the same level of attention to risk management because of a chemical shift in their brains. They become slightly bored and push the limits of their abilities and risk exposures in order to continue to feel challenged. The combination of low relative dopamine levels during during trading (because they have already learned profitable techniques) and elevated norepinephrine levels provokes increased boredom, distractibility, and scanning for new opportunities.”
Too much success, in effect, can change an investor’s brain and lead to chemically based overconfidence that will lead to excessive risk taking.
To be clear, as we attempted to highlight in the quote from Buffet at the start of this note, confidence in your abilities is also critical in the achievement of investment success, and success in life broadly. If you do not believe in your process and your team, then your ability to make timely decisions will be limited, but this confidence must be framed in rationality. In effect, you can only achieve what you believe you can achieve. As Jack Schwager wrote in Market Wizards:
“One of the most strikingly evident traits of all the market wizards is their high level of confidence . . . But the more interviews I do with market wizard types, the more convinced I become that confidence is an inherent trait shared by these traders, as much as contributing factor to their success as a consequence of it . . . An honest self appraisal in respect to confidence may be one of the best predicators of trader’s prospects for success in the markets.”
A starting place of any success, whether in investing or otherwise, is in confidence, but at the same time we must be very wary of the pitfalls of overconfidence. A method we use at Research Edge is to keep investment journals. While this seems trivial, it is also a way to quickly and accurately verify when your success is based on skill versus luck. It also provides us the ability to look back and learn from our mistakes.
Daryl G. Jones