I, along with most investment advisers and financial planners, generally caution my clients to only look periodically at their portfolios; quarterly, or, preferably, annually. The less you look at your portfolio, the less tempted you are to stray from your plan and to overtrade or make impulsive investment decisions. Value cost average, rebalance, and don’t hit the panic button every time Jim Cramer gets the sniffles, and you should wind up in pretty good shape.
There is, however, a group of people whom I’d advise to look at their investment performance and portfolios every single day. Yes, there’s a group I’d tell to watch their performance like a hawk, manically tracking ups and downs in their handy Excel spreadsheets.
That group? People who are overconfident and overtrade. They’re the ones who tell you that while 89.9 percent of actively managed funds underperformed the Standard & Poor’s 500 index from July 2011 to June 2012, they know what they’re doing.
While we've seen what can happen when you let your limbic system take charge of your trading and that overly confident CEOs can wreak havoc on a stock’s performance. That same overconfidence in investing can shatter your portfolio.
How can you tell if you’re an overconfident investor?
- You’re not depressed. As Cornell University’s David Dunning and Amber Story showed in their article “Depression, Realism, and the Overconfidence Effect,” people who are depressed have a very realistic view of the world. They are not overconfident because optimism is not generally a feeling experienced by those who suffer from depression. This, obviously, is a necessary but not sufficient condition for overconfidence. Let’s look at some more.
- You’re using your net worth to impress others. Overconfidence is often a hallmark of someone who is trying to attain social status. Research from University of California, Berkeley’s Cameron Anderson titled "A Status-Enhancement Account of Overconfidence" shows that “[p]eople who believed they were better than others, even when they weren't, were given a higher place in the social ladder. And the motive to attain higher social status thus spurred overconfidence.” This isn't something you’ll admit to your friends over cocktails, or even to your spouse in the sanctity of your own home, but you know deep down inside if this drives you.
- You miss out on confidence intervals. This is actually pretty easy to measure. For the next 10 trades you make, before you make the trade, think about what you actually expect to happen. For example, you might think, “Apple is going to go up today.” Write down the amount which you’re 90 percent sure Apple will go up by that day. Then, at the end of the day, write down how much the shares actually rose (or fell). You should be right nine out of 10 times. If you’re right less than that, you’re overconfident, and you’re probably overtrading.
If you’re one of those overconfident investors or think you might be but don’t quite want to admit it, what should you do?
According to research from Cornell’s Edward Russo and Paul Schoemaker titled “Managing Overconfidence,” there are three groups of people who consistently avoid all of the hallmarks of overconfidence: weather forecasters, accountants, and geologists exploring for oil.
Comparatively, 64 percent of security analysts were overconfident. The three groups of people who didn’t exhibit overconfidence all get their results of their predictions very quickly. If the weatherman says it’s going to rain within the next 24 hours, then 24 hours later, he knows if he was right or wrong. As the researchers say, “being ‘well calibrated’ is a teachable, learnable skill.”
How do you teach yourself to not be overconfident?
- Get immediate feedback. If you’re going to make a trade, set a timeframe for when the trade should hit its target and then measure whether or not you were right. There’s nothing like seeing a chart full of feedback about your predictions to force you to realize just how right (or wrong) you were. Look at your investment performance every single day.
- Force yourself to think of counterarguments. If you think that Apple’s stock price is going to rise today, make yourself come up with arguments why it will go down instead. The exercise of coming up with just one counterargument was shown in the previously cited Cornell study to reduce overconfidence by almost 40 percent.
- Don’t frame your research with your hypothesis already in mind. Instead of searching for questions like, “Will Apple’s stock rise today?” ask more generic questions. If you ask questions with your end result in mind, you’ll likely find more results that agree with your point of view — in this case, you’ll probably find a bunch of forum posters who say that Apple is guaranteed to go up today — and you’ll create confirmation bias and feed your overconfidence.
- Give yourself a few minutes before committing to your decision. Oftentimes, when you make a decision, you get a rush of adrenaline. That adrenaline leads to a temporary state of euphoria, and it creates a physiological spike of overconfidence. Let the rush die down to where you can make more rational judgments before you act.
If you go through these steps, you’re going to arrive at one of two conclusions. Either you’re as good an investor as you thought, or you’re not quite that good. Congratulations if you are. I hope you can continue the performance in a statistically significant way to prove that you weren't just lucky. However, for the rest of us, who do not have Benjamin Graham’s genes, awareness is important. Once you’re aware of your shortcomings, you’ll adjust your behaviors, reduce overtrading, and be less likely to succumb to the siren song of believing that you can do better than everyone else.
Jason Hull is a candidate for the CFP(R) Board's certification, is a Series 65 securities license holder, and owns Hull Financial Planning.