Are you better than the average driver? According to research, about 90 per cent of us believe we are more skilled than the average driver. This is overconfidence bias, and such overconfidence is both misplaced and dangerous. Of course, statistically, it is impossible for 90 per cent of drivers to be better than average.
This finding is not restricted to “basic” skills or amateurs. In a study of 300 professional fund managers, 74 per cent believed that they had delivered above-average performance; the remaining 26 per cent viewed themselves as average! Incredibly, not one thought they were below average – another clearly impossible outcome.
Many real-life examples illustrate this point. In August, 1998, the Federal Reserve Bank of New York led the bailout of Long-Term Capital Management, a hedge fund run by Nobel Prize winners, after LTCM lost US$553-million in one day. The irony is that LTCM’s models convinced them that the most they could lose in a single day was US$35-million.
In July, pension giant Caisse de dépôt et placement du Québec admitted that the US$150-million investment it had made in Celsius Network LLC, a leading cryptocurrency platform, “raised questions” about their decision and investment process after Celsius declared bankruptcy. Similarly, other Canadian pension plans, including the Canada Pension Plan Investment Board, have been caught out by current market conditions and reported significant portfolio losses in 2022.
They are not alone in being surprised by the market. Central banks around the world are fighting inflation amid criticism that this is a rearguard action that is too little, too late. In this country, for example, the Bank of Canada has raised interest rates 300 basis points so far this year to 3.25 per cent – with more increases likely on the horizon. This is not unique to Canada but is a theme around the world.
What is the lesson here? Don’t trust experts? Put money under your mattress instead of in the stock market? Outsource interest-rate policy to bitcoin instead of central bankers? Not at all. Canadian pension plans and central bankers are well-respected and have strong long-term track records. But the world is a complex place. And stock markets and interest rates are social, not natural constructs. If someone asked 1,000 meteorologists about their weather forecast for tomorrow, their answers would have no impact on the actual weather. However, if someone asked 1,000 professional investors about the level of the stock market tomorrow or inflation, it would have an impact. People will change their behaviour based on their view of how others will react. All this makes it extremely difficult, if not impossible, to accurately predict market or price movements.
Well-trained professionals have the tools and experience to better evaluate stocks or price movements than the average layperson. They might be wrong – that is the nature of these types of social variables – but they will typically be less wrong and less often than non-professionals.
But investors, amateur or professional, would do well to be on guard against the overconfidence bias. It could save them heartache and wallet-ache. Leading research from the 1990s looked at the trading activity of households and found that those which traded the most underperformed the market by about seven percentage points a year, and they underperformed average households by about five percentage points annually. Researchers attributed the result to the overconfidence of the more active investors.
The lesson for investors is that everyone, even experienced professionals, can make mistakes in the market. That is a feature, not a bug, of complex social phenomena. Overconfidence can hurt not just the ego, but also portfolio returns. What are some steps that investors can take to prevent overconfidence bias from wreaking havoc on their portfolios?
- Remember that even Nobel laureates, pension-plan managers and central bankers have been caught wrong-footed. They have access to tools, reports and sources that we don’t. If they can make mistakes, so can we.
- Ask what has to go right in order for your investment decision to be successful.
- Ask what can go wrong that can make your investment decision turn out to be a failure.
- Ask what is within and what is outside your control.
- Remember that diversification – not putting all your eggs in one basket – is an easy way to partly insulate your portfolio from unforeseen events.
“We’re generally overconfident in our opinions and our impressions and judgments,” said Daniel Kahneman, the psychologist and Nobel laureate. As recent experience shows, overconfidence affects all of us. All investors can do is to be aware of the bias, remain humble and approach their portfolios accordingly.
Sam Sivarajan holds a doctorate in behavioral finance and has led wealth management teams at several of Canada’s largest financial institutions. His latest book, Making Your Money Work: The Secrets to Financial Health, has recently been published. For more information, visit www.samsivarajan.com.
Be smart with your money. Get the latest investing insights delivered right to your inbox three times a week, with the Globe Investor newsletter. Sign up today.