Seven deadly sins of investing: Part 1

In Plato's latest series of investor notes, we examine seven investor behaviours that quietly, and repeatedly, destroy wealth. We know them well. We’ve committed every one of them, and probably always will. The hope is simple: awareness does not eliminate bias, but it can reduce its impact and improve decision-making.

These mistakes are not signs of low intelligence or poor training. 

They are hard-wired into us. For millions of years, human judgment evolved to survive predators, famine and tribal conflict, not to manage diversified portfolios of global securities in a hyperconnected digital marketplace.

Deadly sin #1: Overconfidence

The most ubiquitous bias, according to behavioural psychologists, is overconfidence.

Consider the evidence. Ninety-three percent of drivers rate themselves as better than the median driver - a mathematical impossibility. 

A clear majority of people believe they are better lovers than average. Even among academics, 94% of university professors rate themselves above the median professor. Political leaders routinely overestimate the probability of swift military victories - from Vietnam to Iraq to Afghanistan, and more recently Ukraine and Iran. In financial markets, male investors trade around 45% more frequently than women, and as a result underperform by roughly 1% per annum after costs.

Overconfidence is universal. Markets simply provide a mechanism to monetise it.

And it can be financially ruinous. Portfolios become overly concentrated. Risk factors cluster. Exposure narrows to a handful of correlated thematics (think concentrated US software bets at present). During the GFC, we held concentrated short positions in several European banks. When Mario Draghi pledged to do “whatever it takes” to preserve the euro, those stocks surged. We were caught on the wrong side and lost more than I care to remember. Conviction is admirable. Uncalibrated conviction is expensive.

Research in psychology shows that when people say they are 90% certain about something, they are actually correct only 75–80% of the time. More concerning still, when people say they are 100% certain, they turn out to be right only 85–90% of the time.

So, are you overconfident?

Here is a simple calibration test drawn from the behavioural literature. For each question below, write down a low and high estimate such that you are 90% confident the true answer lies between them. If you are well calibrated, 90% of the true answers should fall inside your ranges.

Only check the answers after you have committed your intervals to paper (answers in comments).

1. What is the length of the Nile River (in km)?
   
2. What is the population of Bangladesh?
   
3. What is the height of Mount Everest (in metres)?
   
4. What is the average distance from Earth to the Moon (in km)?
   
5. What is the annual wheat production of Australia (in tonnes)?
   
6. What is the diameter of the Moon?
   
7. What is the gestation period of an African elephant (in months)?
   
8. In what year was Mozart born?
   
9. What is the approximate coastline length of Tasmania (in km)?
   

How did you go?

If, like me, more than one of the true answers fell outside your ranges, you are likely overconfident. In controlled experiments, participants who believe they are 90% certain typically capture the correct answer only about 50% of the time. We are not bad at estimating. We are bad at estimating how uncertain we are.

Probability does not always come naturally

I’m reminded of the classic line from Anchorman, where Paul Rudd’s character proudly describes his Sex Panther cologne: “60% of the time, it works every time.”

The irony is that a degree of overconfidence may be necessary to function. If we perfectly understood the uncertainty embedded in life, and markets, we might struggle to act at all.

Dr David Allen in Plato Investment Management's Head of Long/Short Strategies and Portfolio Manager of the Plato Global Alpha Fund. 

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