The Hazards of Combining Overconfidence and Investing

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Daniel Kahneman, behavioral economics guru and Nobel Prize winner, has a new book out called Thinking, Fast and Slow. This one is definitely on my to-read list. You may remember him from his TED Talk about Happiness = Earning $60,000 A Year?

He wrote an article for the NY Times called Don’t Blink! The Hazards of Confidence (a little jab at Gladwell?), which covers one of the cognitive fallacies discussed in the book caused by overconfidence amongst professional stock-pickers and money managers. First, he covers what some of you may already know about the performance of actively-managed mutual funds:

Mutual funds are run by highly experienced and hard-working professionals who buy and sell stocks to achieve the best possible results for their clients. Nevertheless, the evidence from more than 50 years of research is conclusive: for a large majority of fund managers, the selection of stocks is more like rolling dice than like playing poker. At least two out of every three mutual funds underperform the overall market in any given year.

More important, the year-to-year correlation among the outcomes of mutual funds is very small, barely different from zero. The funds that were successful in any given year were mostly lucky; they had a good roll of the dice. There is general agreement among researchers that this is true for nearly all stock pickers, whether they know it or not — and most do not. The subjective experience of traders is that they are making sensible, educated guesses in a situation of great uncertainty. In highly efficient markets, however, educated guesses are not more accurate than blind guesses.

The second story was more personal, and had to do with a small group of financial advisors.

I asked for some data to prepare my presentation and was granted a small treasure: a spreadsheet summarizing the investment outcomes of some 25 anonymous wealth advisers, for eight consecutive years. The advisers’ scores for each year were the main determinant of their year-end bonuses. It was a simple matter to rank the advisers by their performance and to answer a question: Did the same advisers consistently achieve better returns for their clients year after year? Did some advisers consistently display more skill than others?

To find the answer, I computed the correlations between the rankings of advisers in different years, comparing Year 1 with Year 2, Year 1 with Year 3 and so on up through Year 7 with Year 8. That yielded 28 correlations, one for each pair of years. While I was prepared to find little year-to-year consistency, I was still surprised to find that the average of the 28 correlations was .01. In other words, zero. The stability that would indicate differences in skill was not to be found. The results resembled what you would expect from a dice-rolling contest, not a game of skill.

My, that must have been an uncomfortable presentation! Investing is an area where it is very hard to discern skill from luck, so be careful when asked to pay a nice chunk of money for it, be it through mutual fund expense ratios or portfolio management fees.

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  1. Based only on its Amazon description, “Thinking Fast and Slow” can probably be summarized as ‘be cautious with snap judgments’. Another book called “The Arrogance Cycle: Think You Can’t Lose, Think Again” can probably be summarized as ‘market euphoria causes investor overconfidence’. You could argue that thinking fast is more for day traders and thinking slow is for investors. My collective take from both books (both released this fall at around $16, each with four 5 star Amazon reviews) is that you can attempt to make educated guesses on buying low and selling high, but that strategy works only if the investment actually goes up. Investments go up on the blind hope that there will be no unpredictable negative factors weighing in such as a macro-economic catastrophe, fraudulent behavior, or the evolution of an investment with a superior competitive advantage. Not too long ago, I would have said investments like Nokia, Janus mutual funds, or European banks were brilliant moves. While Deutsche Bank is up 15% this morning, I would be hesitant to invest here and more likely to do some amateur day trading and sell on the rallies.

  2. Vince Thorne says

    A fund manager is heavily restricted in the amount of stock he/she can buy from one company. Hence, big funds are forced to buy stocks that are not on their tier 1 list inorder to keep their clients money invested. An individual has no such restrictions. If you have a good understanding of the amrket, you can make your investments grow.

  3. If you have a good understanding of the amrket, you can make your investments grow.

    That’s a mighty big “if.”

  4. I don’t deal in ifs. I managed to find a guaranteed way of getting a 4-7% return per year. Stable and guaranteed is the best way for me to invest. I’m just not cut out for the ups and downs of the market. Not good for my health I’m afraid. Good luck to those taking the roller coaster ride in stocks.

  5. Thanks for the book tip — reading about Kahnemann’s & Tversky’s behavioral microeconomics was probably the most interesting part of my degree in economics!

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