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Thursday, 7 May 2009

Overconfidence and Over Optimism

Behavioural Biases (1): Overconfidence and Over Optimism

Most of us are way too confident about our ability to foresee the future and overwhelmingly too optimistic in our forecasts. This finding holds across all disciplines, for both professionals and non-professionals with the exceptions of weather forecasters and horse handicappers.

To add the problems it also turns out that the executives running the companies we invest in so hopefully suffer from the same problems. Overconfident, over optimistic investors investing in companies run by overconfident, over optimistic executives. What could possibly go wrong?

Overconfident Investors

The overconfidence problem is a regular behavioural issue – the so-called Lake Wobegon Effect:
all the women are strong, all the men are good-looking, and all the children are above average
So 80% of students think they're above average drivers, all states claim above average student test scores and, of course, most investors think they're above average moneymakers. There are a lot of seriously deluded people out there.

Overconfidence is only one part of the equation – it’s one thing to believe you have better judgement than you actually have, but it’s entirely another to be biased positively. Over optimistic people will have an unrealistic expectation of how often they’ll get a good result versus a bad result.

It’s not hard to imagine similar problems among those of us self-centred and arrogant enough to think we can beat the investment industry at its own game. So it proves. Glaser and Weber (200) ran a neat study on internet based private equity investors which showed that the more confident the investor was in their own ability the more they traded.

This builds on research by Barber and Odean (2002) which argued that generally online traders were overconfident and overtraded anyway. Their conclusion was:
Overconfident investors were more likely to go online and once online the illusion of control and the illusion of knowledge further increased their overconfidence. Overconfidence led them to trade actively and active trading caused subpar performance”.
Oh, and they showed that men were more confident than women (and got worse returns).

What’s Wrong with Lots of Trading?

By and of itself lots of trading may not seem like a bad thing, but the research begs to differ. As far back as 1915 a stockbroker going by the pseudonym 'Dan Guyon' did his own research to show that clients managed to lose money even while the stocks they were investing in increased by 65%. Worse still, the investors thought they’d done pretty well - that's cognitive dissonance for you.

The QAIB study from Dalbar, Inc. regularly shows that mutual fund investors massively underperform the market due to a combination of high mutual fund fees and terrible investment decisions. The gap between market returns and investor returns varies over time from a scarcely believable underperformance of a 300% to a staggering 500% – investors in some years only made one fifth of what they’d have got in an index tracker.

Still, can’t happen to us, eh?

Judgement under Uncertainty

Overconfidence and over-optimism are particularly prelevant when decisions must be made in conditions of uncertainty – or when there are comparisons to be made with other people. There are lots of laboratory based studies that regularly show how traders don’t just misunderstand themselves but also interpret other people’s results so as to inflate their own performance.

Generally, though, humans are learning machines. If we make trading mistakes due to these biases we should, eventually, correct them and – you would think – more rational traders would result. Yet, the biases seem to have lives of their own.

It seems that the traits are linked to personality and are hard to eradicate. Positive trading results reinforce the biases while negative ones are usually explained away by some manipulation of personal reality. In particularly bad cases more money may be thrown at an investment in a refusal to accept a mistake. That way lies madness.

Professional Misjudgement

Perhaps the key to this is that these biases aren’t just experienced by private investors who, as a group, might be expected to be less professional and more emotional. No, in fact the traits are shown across all investors – private, professional, fund managers and analysts. Everyone’s at it.

Moreover, there are new investors coming to the market all of the time, mostly overconfident in their own abilities and over optimistic in their expectations for returns. This argument was neatly in a paper by Lynn Stout: Technology, Transaction Costs and Investor Welfare: Is a Motley Fool born every minute?
I am struck by the image of a world in which milions of investors daily waste hours at their computers, surfing the Motley Fool and similar "resources" in their statistically hopeless quest to beat the market.
Well, that sounds worryingly and personally familiar.

Markets are Not a Zero Sum Game

Underlying this is the problem that markets are a negative sum game. For every transaction there is a winner and a loser after the trade is made. Once fees are added to this the net result is that between the two participants in the trade there is an overall loss. Every trade adds to this loss, as the missing money finds its way to the securities industry through fees and buy-sell spreads.

Rationally it’s not sensible to trade anymore than you absolutely need to. Both traders believe that they’ll win through the exchange yet one of them is definitely wrong. Overconfidence and over optimism leads to excess trading.

Given Arnotts’s recent research showing the long-term outperformance of bonds over shares it’s interesting to note that Benartzi, Kahneman and Thaler carried out some research for Morningstar on the probability of such a happening. A third of their sample believed there was no chance of this happening, ever. So much for rational judgement.

Overconfident Managers

Of course, investors are often using information and expectations emanating from the companies themselves to judge whether or not their investments have merit. Sadly it seems that the executives of these companies are themselves prey to the same kinds of biases that cause many investors to underperform.

There are lots of bits of research showing that executives don’t lack for animal spirits, believing they have more control over situations than is actually true and that they have an excessive degree of commitment to “good” outcomes. See, for example, Malmendier and Tate (2004) which gives a good overview of the topic.

So with biased investors investing in companies managed by biased managers you’ve got to wonder exactly where all the rational investors have gone. At a guess they’re at home watching TV, cooking dinner or doing something – anything – that isn’t actively investing.

The Loser’s Game

Like it we may not – and I have many years of experience to offer in this regard – but the evidence overwhelmingly suggests investors of all kinds trade too much and damage their returns horribly by doing so. Most active investors must lose against the market – the negative sum game by which the investment industry extracts its pounds, kilos and bucket-loads of flesh guarantees this.

For the vast majority of investors it makes absolutely no sense to be confident or even particularly optimistic about the returns they can generate by actively trading. The numbers are against us and trying to beat those numbers is likely to lead us more and more astray.

Of course, if overconfidence and over optimism were the only behavioural biases we needed to worry about then we might, just, be able to overcome these on the way to becoming better investors. Sadly they only touch the surface of the mental maelstrom that lies beneath the placid surface of your average trader.

And don’t bet against professional horse handicappers or weather forecasters either.

Next Time: Behavioural Biases (2): Hindsight Bias

Related Posts: It's Not Different This Time, The Psychology of Scams, Unemotional Investing is Best

1 comment:

Anandh Sundar said...

"Glaser and Weber (200) ran a neat study on internet based private equity investors which showed that the more confident the investor was in their own ability the more they traded"..maybe you meant private individual investors instead of private equity investors :P