In This Market, Guard Against Complacency
Key Takeaways
Studies of human behaviour have found overconfidence as “the most significant of the cognitive biases”. After all, if we weren’t confident, we would be clinically depressed.
The ongoing bull market across various asset classes (and even cryptocurrencies) can cause investors to overestimate their own trading abilities.
When the market is up for most, it’s easy to feel smart, but the truth is, historical evidence shows that investors lose out by large margins when they trade frequently or try to pick the winning asset or stock.
So ask yourself, Does the investment make sense? — in terms of economic value, future cash flows, and profitability? Does it fit into what you intend to do?
The illusion that we understand the past fosters overconfidence in our ability to predict the future.
— Daniel Kahneman
The study of how psychological biases affect financial decision-making has become more mainstream over the recent years thanks to the excellent research led by Nobel Laureate Daniel Kahneman, who passed away recently.
In his book Thinking Fast and Slow, Kahneman called overconfidence “the most significant of the cognitive biases”. Human beings broadly tend to be over-optimistic about our abilities and life prospects, which feeds into how we make decisions. Overconfidence includes over-placement (over-estimation of one’s rank in a group of peers) and over-precision (over-estimation of the accuracy of one’s beliefs). Such overconfidence has been documented among experts and professionals, including company CEOs, corporate financial officers, as well as professional traders and investors.
Surveys conducted over the years have pointed to this overconfidence — even this humorous example shown below about the animals people believed they could beat in a fight. Even if it appeared docile, personally we would rate our chances at beating an elephant, which weighs more 53 times heavier than us, near zero. However, nearly 20% of the people surveyed thought they could beat one.
Pockets of Overconfidence in the Investment Landscape
The ongoing bull market is creating pockets of overconfidence in some asset classes. Not only are stocks doing well, cryptocurrencies such as Bitcoin have hit record highs this year. After a slump in 2022, brokers are again reporting good profits as retail traders return after a two year absence. In addition, Google Trends indicates that users searching for investments reached a peak in March this year. An issue from this overconfidence, is that it makes investors overestimate the precision of their information and their own trading abilities. When the market is up for most, it’s easy to feel smart or like an investment guru.
However, a wealth of academic evidence shows that investors hurt their long-term performance by trading frequently, a symptom of overconfidence in an ability to pick winning stocks, bonds or funds. In addition, trading individual stocks causes investors to lose out on a diversified market. Odean and Barber's 2002 report, "Trading Is Hazardous to Your Wealth: The Common Stock Investment Performance of Individual Investors", found that investors who traded individual stocks underperformed the market by more than 5% per annum. We have written about the difference between trading and investing before.
Weigh The Evidence
So in this current bull market, guard against complacency and be aware of the various biases stacked up against us.
If you are in it for the thrill, it is absolutely fine. Treat your (losses from) trading as an entertainment fee by apportioning a small amount of your assets for it. Definitely avoid throwing everything in, including the kitchen sink.
If you feel certain that your investment prowess was above average, it might be good to take a look to the past. What were your worst investment moves? Did your wins exceed your losses and how did that compare to the broad market? Positivity bias or distortion/selective forgetting affects us in a way that we remember past investment wins as more positive than they were and past losses as less negative.
Fall back on historically-tested principles. Don’t change your well constructed and thorough investment plan because of a confidence boost. Think twice (or thrice) about amending your asset allocation over something you just heard or a feeling you had. Ask yourself, Does the investment make sense? — in terms of economic value, future cash flows, and profitability? Does it fit into what you intend to do?
These simple checks can help reduce overconfidence and help guard against complacency especially when the market is doing well and people around you are feeling FOMO.
If you are considering a new investment and would like an independent second opinion, come and speak to us.
