What Can Investors Do About Overconfidence?

Overconfidence can have a profound impact on our decision making, but can be difficult to acknowledge and even harder to rectify.  It also seems likely that overconfidence is a particularly pernicious bias in the investment industry, for the following reasons:

– Selection bias: There is probably a selection bias into front office investment management roles – that is overconfident individuals are more likely to ‘ascend’ to such positions.

Overvaluing overconfidence: Related to the prior point – overconfidence tends to be an effective career strategy. Against an uncertain backdrop we seem to value those who take bold and singular views, whilst being scornful of pragmatism, nuance and probabilities.

Overconfidence is easy: When operating in an environment marked by randomness and uncertainty it doesn’t take a great deal to make an overconfident decision.

The potential implications of overconfidence are significant and include: overtrading, lack of diversification, attribution error and a tendency to take positions with unfavourable odds – to name but a few.  Although there is no perfect remedy for overconfident decision making, there are certainly simple steps we can take to mitigate it.  These are my preferred measures:

1) Take the outside view:  This concept has risen to prominence in recent years, mainly thanks to Michael Mauboussin and Daniel Kahneman.  Taking the inside view relates to being reliant on your own individual experience and specific circumstance, whilst the outside view is based on evidence from a relevant reference group – what is the general experience from similar situations?

For example, assume you were considering investing in an active manager.  The inside view would be the great meeting that you held with manager, their impressive track record and pedigree of the team. The outside view would be that only 10% of active managers in the asset class have outperformed over the past decade. Absent the outside view, you would be liable to neglect the unfavourable odds of investing in the active manager and the level of overconfidence you may be exhibiting by doing so.

2) Think in probabilities and bets[i]:  Although we seem to have an unescapable desire for spurious precision and aggressive singular forecasts, we should resist these and instead think in terms of probabilities. Ascribing probabilities to different potential outcomes reduces the chance that we become wedded to a particular view, prevents us ignoring low likelihood risks and, crucially, leaves us free to alter our perspective when new information arrives.  Changing your position when you have made a strident, binary forecast is fraught with difficulty; adjusting probabilities is far easier.

3) Assume you are average:  A good check on any investment decision is to ask – should this decision work on average? Or, in other words, are the odds in my favour?  Try to take decisions where there is evidence that it is a sensible long-term decision – for example, favouring cheaper assets versus more expensive assets over the long-term. Taking such an approach can give an insight into how much reliant you are on your own skill for an investment view to come to fruition.

4) Think about who is making the decision:  Whilst there is an assumption that group decisions should be less impacted by overconfidence than solo decisions, this is not necessarily the case – a group comprised of similar individuals may be emboldened by the consistency of their views and display even greater overconfidence. Group composition matters. A recent study[ii] showed that diverse groups (from a gender perspective) were better calibrated than individuals and all male groups.  Although research in this area is nascent – diversity is likely to be a crucial consideration when thinking about overconfidence.

5) Carry out a pre-mortem: Pre-mortems are a simple means of dampening overconfidence[iii].  Before making an important decision, ask a group of people to imagine that you have implemented the decision and it has proved disastrous, then to list the possible reasons for the failure. This is a great way to encourage devil’s advocacy and break down hierarchical structures that may inhibit individuals from questioning the decision of their ‘superiors’.

6) Record and review decisions:  It sounds simple, but is so rarely done – make sure that you appropriately record decisions when they are made (including why you are making them) in order that you are able to assess the quality of your judgements in the future.  Rather than doing this, our tendency is to not consider past decisions at all, or review them with the benefit of hindsight and retrofit our rationale based on information we didn’t have at the time. Looking at historic decisions is difficult and shines a light on just how tough it is to operate in financial markets; but the feedback is invaluable. Always remember to review decision quality not outcome quality as unfortunately the two are not synonymous.

References:

[i] Duke, A. (2018). Thinking in Bets: Making Smarter Decisions when You Don’t Have All the Facts. Penguin.

[ii] Keck, S., & Tang, W. (2017). Gender composition and group confidence judgment: The perils of all-male groups. Management Science.

[iii] Klein, G. (2007). Performing a project premortem. Harvard Business Review85(9), 18-19.

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