Investment psychology
Confidence is a feeling
Many investors like to focus their investing on high conviction ideas. This could include decisions about asset allocation, stock selection or any other important choices. It is thought we can have greater confidence in those decisions and thus cut our investing risks. But, confidence is a feeling. Hold that thought for a moment.
This post will be the seventh and last of a series of posts that deal with the most important behavioral biases and cognitive errors that bedevil us as investors. It contains my list of gap-to-edge rules we can adopt to mitigate the problem.
In this post I want to weave some ideas around confidence and optimism that act upon our animal spirits when we make investment decisions. Animal spirits is Maynard Keynes notion.
“Most, probably, of our decisions to do something positive, the full consequences of which will be drawn out over many days to come, can only be taken as a result of animal spirits – of a spontaneous urge to action rather than inaction, and not as the outcome of a weighted average of quantitative benefits multiplied by quantitative probabilities. (Keynes, The General Theory 1936,2007) p.161.” (emphasis added)
Warren Buffett encourages investors to approach investing decisions in a probabilistic fashion. But what he means is the use of intuitive probabilities. The future is always uncertain and not subject to quantification. And, of course, investing is always about the future.
Confidence is a feeling
Daniel Kahneman, tells us: “Subjective confidence in a judgment is not a reasoned evaluation of the probability that this judgment is correct. Confidence is a feeling, which reflects the coherence of the information and the cognitive ease of processing it.” (Kahneman, 2011)p.212. Subjective Confidence can even lead experts (or at least supposed experts) to misunderstand the limits of their own expertise.“(Kahneman, Thinking, Fast and Slow 2011) p.242.
So when investors and analysts talk about high conviction ideas they are in human foibles territory.
To really understand what Danny Kahneman is talking about you need to read Thinking, Fast and Slow. There is a world of meaning in the phrases “the coherence of the information and the cognitive ease of processing it.”
Confidence and optimism
Kahneman writes: “An optimistic attitude is largely inherited, and it is part of a general disposition of well-being, which may also include a preference for seeing the bright side of everything.” (Kahneman, 2011) p.255. (Emphasis added)
Kahneman explains: “Most of us view the world as more benign than it really is, our own attributes as more favorable than they truly are, and the goals we adopt as more achievable than they are likely to be. We also tend to exaggerate our ability to forecast the future, which fosters optimistic overconfidence. In term of its consequences for decisions, the optimistic bias may well be the most significant of the cognitive biases.” (Kahneman, 2011)p.255. (Emphasis added)
My supposition
Kahneman tells us that: “Optimism is normal, but some fortunate people are more optimistic than the rest of us.” (Kahneman, 2011) p.255. It is apparent from this that Kahneman doesn’t put himself in the fortunate optimist camp.
Buffett and Templeton
From all my reading I put both Warren Buffett and John Templeton in the camp of supreme optimists. But somehow it does not morph over into optimistic overconfidence. Somehow they are able to be both supremely optimistic and grounded in reality.
For decades the most popular investing show on television was Louis Rukeyser’s Wall Street Week on Friday nights on PBS. John Templeton appeared frequently on the show and one memorable program was the Friday following October 19, 1987 that saw the Dow Jones Industrial Average decline 22.6% on just that one day.
Rukeyser asked Templeton for his advice to investors in that moment of crisis. This from the transcript:
Sir John: “Patience. Be a long-term investor. Be prepared financially and psychologically to live through a series of bull markets and bear markets because in the long run common stock will pay off enormously and the next bull market will carry prices far higher than this one.”
It wasn’t that he was exhibiting rose-colored-glasses optimism. It wasn’t that he was showing extraordinary courage in the face of a horrific decline. The personal qualities most evident that day were optimism and calm in the face of turmoil. Danny Kahneman would probably say of Templeton that he had “a preference for seeing the bright side of everything.”
I would modify that slightly. An optimist is capable of seeing the bright side when there is a bright side and knowing the difference.
Conclusion
Optimistic overconfidence can be a killer. Skillful investors have the confidence to take action when all the world around them is in turmoil. They also have the humility to know the limits of their own investment ability. There is confidence and overconfidence and experienced investors know the difference.
Let me give you my gap-to-edge rules to counter overconfidence and an optimistic bias. They are my version of what Daniel Kahneman (Nobel Prize in economics) calls risk policies. Kahneman describes risk policies as decision rules that are always applied in similar situations. Avoid your behavioral gap and gain an edge over Mr. Market’s foibles.
This post is part of a multi part series titled ‘A set of rules to develop a behavioral edge’.
So far there have been six posts and six sets of gap-to-edge rules:
Part 1 The problem of short-term thinking.
Part 2 The attractive trap of extrapolating the most recent past into the future
Part 3 Control our animal spirits when faced with risky situations.
Part 4 The herd mostly gets it wrong
Part 5 Our minds search for confirming evidence
Part 6 We generalize from limited observations
To complete the set
I did an earlier post that deals with the problem that many investors’ “judgments and decisions are guided directly by feelings of liking and disliking, with little deliberation or reasoning.” This is the situation where you like Tesla cars and this is essentially the only reason you buy the stock. This is really the eighth post with gap-to-edge rules and completes the set.
Part 8 The worst behavioral bias – jumping to conclusions
Gap-to-edge rules for this post
Coming back to overconfidence and optimism. At risk of oversimplification, it seems to come back again and again to the old adage that success is 10% inspiration and 90% perspiration. So let us look at some gap-to-edge rules that should serve to address some of these overconfidence and optimistic bias issues.
Gap-to-edge rule: Sleep on every decision.
Over confidence can lead to snap decisions. Even two nights sleep makes for a good rule. I place orders on the internet on Saturdays and have until Monday to reflect. Give your System 2 a chance to think and reflect on the beliefs and intuitions of System 1.
Gap-to-edge rule: When things are going well be especially wary and stay attached to reality.
This is one of the most dangerous times in investing. Our success may well be the result of good luck. In bull markets we tend to lose sight of the fact that a bear market will be just around the corner.
Gap-to-edge rule: When the wheels are falling off the market and all around are losing their heads, keep perspective, frame broadly and stay attached to reality.
Gap-to-edge rule: Always do your homework.
Daniel Kahneman’s System 1 can lead us to grief if we are not careful. One way to counter this is to ensure that every investment decision is accompanied with proper due diligence.
Gap-to-edge rule: Disregard pundits entirely except for amusement.
We have seen this gap-to-edge rule before. It crops up again because this time it applies to combatting overconfidence.
Gap-to-edge rule: Ensure that management and directors have skins in the game.
This gap-to-edge rule comes up again.
Gap-to-edge rule: Read quarterly and annual reports with a keen view to detecting executive hubris and overconfidence.
Management tend to be an optimistic lot. Watch out for signs of excess.
Gap-to-edge rule: Limit the time you give yourself to outperform the indexes.
You may think of yourself as an investor with above average skills. You may not be.
You may not be a better than average driver. We all believe we have superior intelligence and skills. We are all overconfident. At some point, it will become clear if an investor is not outperforming the indexes. At this point a move to a low cost index fund is indicated.
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Readers wishing to read deeper into this subject can check out the Motherlode Chapter 18. Over-confidence and optimism
And particularly Sections:
18.01 Overconfidence and optimism
18.03 The normal state of the world
18.04 Over-confidence and confidence in one’s own judgment
18.07 The problem of overconfident management
18.08 What is to be done about overconfidence and optimism?
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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.
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You can reach me by email at rodney@investingmotherlode.com
I’m also on Twitter @rodneylksmith
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Check out the Tags Index on the right side of the Home page that goes from ‘accounting goodwill’ to ‘wisdom of crowds’. This will give readers access to a host of useful topics.
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You can also use the word search feature on the right-hand side of this page to find references in both blog posts and also in the Motherlode.
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There is also a Table of Contents for the whole Motherlode when you click on the Motherlode tab.
Want to dig deeper into the principles behind successful investing?
Click here for the Motherlode – introduction.
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