Investment psychology
Without losing track of reality
Two thoughts: The easiest way to lose money in the stock market is through being optimistic, overconfident and over aggressive.
It’s impossible to achieve superior investing results without being an optimist.
These two statements don’t sit well together. They represent a paradox. Optimism is essential for superior investing results but can be harmful to your financial health.
My Oxford dictionary defines optimism as an inclination to take favorable views.
In this post I propose to dig into this dilemma. There are two parts to the discussion. We will learn first about the optimism bias and then the risks of the overconfidence bias and the risks of high conviction ideas. Then we will look at the optimism quotient of two high profile and very successful investors, John Templeton and Warren Buffett, and draw some conclusions about optimism and superior returns.
Some people are optimistic by nature
In the early 1970s, Amos Tversky and Daniel Kahneman, two Israeli psychologists, started working together on the subject of people’s attitudes to risky choices. This was the beginning of the study and application of behavioral psychology to decision making. Ultimately Kahneman, following the death of Tversky, became a recipient of the Nobel Prize in Economic Sciences. Tversky would undoubtedly have shared the prize had he been alive. Today their ideas have become an important adjunct to economics and finance.
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, Thinking, Fast and Slow. 2011) p255
He adds: “In terms of its consequences for decisions, the optimistic bias can be both a blessing and a risk, you should be both happy and wary if you are temperamentally optimistic.” (Kahneman, 2011) p255
Put another way, he writes: “…the blessings of optimism are offered only to individuals who are only mildly biased and who are able to ‘accentuate the positive’ without losing track of reality.” (Kahneman, 2011) p256
Kahneman tells us that: “Optimism is normal, but some fortunate people are more optimistic than the rest of us.” (Kahneman, 2011) p255 It is apparent from this that Kahneman doesn’t put himself in the fortunate optimist camp.
What I gather from this is that optimism is a personality trait that is largely bread in the bone. Some people are naturally more optimistic than others. Optimists, as the common saying goes, see the glass as half full – the bright side. Pessimists see the glass as half empty – the dark side.
Optimistic Overconfidence
Kahneman writes: “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) p255 (Emphasis added)
In a word, ‘optimistic overconfidence’ can be dangerous to our financial health!
The risks of high conviction
One other point needs to be made. It’s about our convictions. He points out that: “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) p212 Subjective Confidence can even lead experts (or at least supposed experts) to misunderstand the limits of their own expertise. (Kahneman, 2011) p242
In a word, the strength of our conviction in the rightness of our beliefs is no indication that they are correct. To read more on this see my post: The frailty of high conviction ideas
Optimism and overconfidence – Summing up
Some people are more optimistic than others. We all view our own attributes more favorably than they truly are. We all think we are superior car drivers. Humans generally tend to be overconfident. This is especially true of the optimists amongst us. Our high conviction ideas may not be correct.
What can we say about the world’s greatest investors?
When all about you is in turmoil
Since I began investing in 1972 the greatest setbacks in the stock market have come in 1974, 1987, 2000 and in 2008. Let’s look at the reaction of two great investors to three of those events.
Warren Buffett
After Warren Buffett liquidated the partnership in 1969 the Dow Jones Industrial Average tried for several years to break out above 1000 without success. By October 1974 it had plunged to 580. As Roger Lowenstein puts it, bruised market professionals were in ‘Chicken Little’ mode.
Buffett was interviewed by Forbes magazine in October 1974:
“How do you feel? Forbes asked.
“Like an oversexed guy in a whorehouse. This is the time to start investing.” Buffett said. (Lowenstein, Buffett, The Making of an American Capitalist. 1995,2008) p161
The Great Financial Crisis blew up in 2008. The world was a horrendously uncertain place. Warren Buffett wrote in his 2010 letter to the shareholders of Berkshire Hathaway:
“Money will always flow toward opportunity, and there is an abundance of that in America. Commentators today often talk of “great uncertainty.” But think back, for example, to December 6, 1941, October 18, 1987 and September 10, 2001. No matter how serene today may be, tomorrow is always uncertain.
Don’t let that reality spook you. Throughout my lifetime, politicians and pundits have constantly moaned about terrifying problems facing America. Yet our citizens now live an astonishing six times better than when I was born. The prophets of doom have overlooked the all-important factor that is certain: Human potential is far from exhausted, and the American system for unleashing that potential – a system that has worked wonders for over two centuries despite frequent interruptions for recessions and even a Civil War – remains alive and effective.
We are not natively smarter than we were when our country was founded nor do we work harder. But look around you and see a world beyond the dreams of any colonial citizen. Now, as in 1776, 1861, 1932 and 1941, America’s best days lie ahead.”
I think we can classify Warren Buffett as a supreme optimist.
John Templeton
Sir John Templeton was educated at Yale and Oxford and founded the Templeton Growth Fund in 1954. Templeton pioneered global diversification in the mutual fund industry. He was probably one of the two or three greatest investors of the 20th century.
Templeton was interviewed on television the Friday following October 19, 1987 when the Dow Jones Industrial Average decline 22.6% on just that one day, the most dramatic one day drop in stock market history:
“Louis Rukeyser: What is your advice to people in terms of the stock market now?
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.
Louis Rukeyser: Why?
Sir John: Because the whole nation is growing more rapidly. Gross national product of the nation will double at least in the next ten years. We think the gross national product of the nation forty years from now will be sixty-four times as high as it is now and that will be reflected in sales volumes and profits and share prices….” (Proctor & Phillips, The Templeton Touch, 1983, 2012) p222
Marty Flanagan tells us that the experience of working closely with John Templeton during the crash of October 1987 helped him to keep perspective during the bruising market collapse in the fall of 2008 when he was CEO of Invesco, one of the largest global asset managers in the world. Flanagan reports: “Honestly, those experiences helped me during this last crisis.
He [Sir John] was always optimistic, he always took the positive point of view, and that would be an influence on how I approach things. If you think that way, if you think optimistically, you also see the opportunities.” (Proctor & Phillips, 1983, 2012) p191
Proctor feels that the essence of Templeton’s personality was his ‘positive thinking’. But he quickly adds: “But it’s also essential not to allow an emphasis on his positive thinking to overshadow the realism of his in-depth market research and the hard-headed way he evaluates one corporation against another. He’s certainly no Pollyanna when it comes to dumping a loser in favor of a stock he considers a bargain.” (Proctor & Phillips, 1983, 2012) p124
John Templeton was also a supreme optimist.
I believe Buffett and Templeton were only able to be great investors because they were supremely optimistic. I think if they had merely been ‘mildly optimistic’ to use Danny Kahneman’s term, they would not have achieved the long term superior results they did. But, nobody would ever accuse either Buffett or Templeton of ‘losing track of reality’.
Conclusion
Another quote from Warren Buffett sums it up: “We simply attempt to be fearful when others are greedy and to be greedy only when others are fearful.” The optimist will see the opportunities when all around them see difficultly. But the optimist also has to develop the learned instinct to be fearful when all around are greedy. As well, the optimist has to remain disciplined with an investment process that emphasizes value and the long view. This advice works well for investing in the overall market with index funds and even better for investing in individual stocks that are offered up at bargain prices at various times.
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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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