The frailty of high conviction ideas

Behavioral biases

Over-confidence and confidence in one’s own judgment

Investing involves making a lot of tough judgement calls. We are convinced the company has a great future and think the stock cheap. But, of course it will be cheap for a reason. Let’s say management is guiding for lower future sales and/or profits because they are investing in the business for the long term and sacrificing short term earnings and the street has gone cold on the company.

It is especially tough to buy or even hold a stock when most other investors are shunning it. So, we need to have full confidence in our judgement about this company if we are to make a serious financial commitment to it.

Here’s the problem. The strength of our belief that we are right has nothing to do with the validity of our judgement. As humans, we tend to have confidence in even our mistaken beliefs. This is because our convictions depend on the subjective coherence of the story we have constructed to support our beliefs. Behavioral psychology tells us that the amount and objective quality of the evidence does not count in deciding how confident we are in our conclusion.

In plain language, we have an idea: Management is investing in the business. We have constructed a story. We like management. We like the business. We like the franchise. But, it’s all a story. And, the more coherent the story, the more confident we are.

Subjective confidence can lead even the most experienced investors to misunderstand the limits of their own expertise. But, we need confidence in our own judgement to make substantial investments, especially when most other investors disagree with our views. What a dilemma.

So let’s reflect on the difference between over-confidence and confidence in one’s own judgement. Over-confidence leads to disaster. Confidence in one’s own judgment naturally comes from having good judgment. And, good judgement leads to investing success.

‘Confidence in one’s own judgement’ begs the question as to how you know if your judgement is sound. In a world filled with behavioral biases and cognitive errors one might ask how one is able to have confidence in one’s own judgment. At first blush that would seem a tall order.

On reflection, sound judgement is simply sound investment decision making. Sound decision making is all about your investment process, or what Ben Graham called ‘principles of operation’. In a speech in 1974 Graham remarked that investing did not require genius: “What it needs is, first, reasonably good intelligence; second, sound principles of operation; third, and most important, firmness of character.”

To learn about this dig into Part 4: Principles of Operation

And to avoid the pitfalls that all humans are susceptible to we need to learn about investment psychology.

Other posts on investment psychology

This post is part of a series. Readers are invited to read Investment psychology explainer for Mr. Market – introduction This will give you a better understanding of some of the terms and ideas and give you links to other posts in the series.

One interesting application of these ideas comes up in portfolio construction and the notion of ‘betting your beliefs’. See Section 36.21 Lessons from the world of gambling – betting your beliefs.

Want to dig deeper into the principles behind successful investing?

Click here for the Motherlode – introduction.

If you like this blog, tell your friends about it

And don’t hesitate to provide comments