Overconfidence

Are you an above average driver? A recent study from AAA found that 73% of US drivers consider themselves better-than-average drivers. That is despite the fact that more than 90% of crashes involve human error. The truth is we are not all above average but we tend to think we are. Unfortunately, our overconfidence is not strictly relegated to our skills behind the wheel. 

Our previous reviews of Confirmation Bias and Hindsight Bias lead to Overconfidence. At its core, overconfidence is a sense that we are above average investors, possess above average information or skills, and believe that we can control the world around us. Unchecked, that combination can lead to disastrous results.

In late 2012 we were approaching what Ben Bernanke, chairman of the Federal Reserve, called the fiscal cliff. Due to expiring tax legislation, the US was facing large tax increases and spending cuts if congress did not act. While it was a very real concern in terms of market outlook, it was one of many. Around Thanksgiving, one of our newest clients, a senior executive at a fortune 500 company, attended an investment committee meeting for their company pension fund. They came away convinced that they had gleaned unique insight about the fiscal cliff, and that the market would crash in 2013. They instructed us to move their entire portfolio to cash. They were displaying enormous overconfidence and fear of loss. We advised them that we did not know how events would unfold. Moreover, things may not play the way they expected. In other words, they could be correct about the event but not the outcome, or they could be wrong about the event entirely. Unfortunately, they could not be dissuaded. 

They sold in early December 2012. To their surprise, the fiscal cliff was narrowly averted when congress passed the American Taxpayer Relief Act of 2012. We called the client on New Year’s day to review this new development. They said, “It is still going to unwind. I want to stay in cash.” As the S&P500 jumped 7% in January, they refused to accept that they had made the wrong decision (cognitive dissonance – another post for another day). Their internal narrative adjusted to fit their view as they sought out any negative information they could find (confirmation bias), and they remained confident that they made the right decision. As the market continued its ascent through the spring, they began to realize the gravity of their miscalculation. Against our advice, they moved millions of dollars out of the market right before it jumped approximately 18% between January and May 2013. It was a mistake that exceeded a half a million dollars in unrealized gains. Eventually, they capitulated and we dollar cost averaged back into the market over the course of that summer. It was a painful, costly lesson about overconfidence, confirmation bias, and hindsight bias.

In the world of investing, intellectual humility is paramount. Very often the bold action that we think will be a great win, can end up being a tremendous financial set back. The reality is that long term success is achieved by adhering to investment principles that work over time, and avoiding emotional decisions to move in and out of the market.

^{This is not a recommendation and is not intended to be taken as a recommendation. This material was prepared for general distribution and is not directed to a specific individual.}

^{LPWM LLC does not provide tax, legal or accounting advice. This material has been prepared for informational purposes only, and is not intended to provide, and should not be relied on for, tax, legal or accounting advice. You should consult your own tax, legal and accounting advisers.}