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There’s a line in Warren Buffett’s 2000 letter to Berkshire Hathaway shareholders, where he says: “Nothing sedates rationality like large doses of effortless money.” *
At the time, of course, Buffett was reflecting on two years of “irrational exuberance” that had swept through the U.S. market - propelling the prices of tech stocks (which were then starting to crash back down).
He noted: “It was as if some virus, racing wildly among investment professionals as well as amateurs, induced hallucinations in which the values of stocks in certain sectors became decoupled from the values of the businesses that underlay them.”
Buffett’s comments are an interesting first-hand account of investor behaviour during a market bubble. A lot of what he describes tallies with what psychologists know about bubbles - which is that overconfidence plays a big part in them.
In the UK, there are few signs that the market is in bubble territory. But that doesn’t mean that investors shouldn’t be wary of the risks of overconfidence. In a recent article on this subject, Don Moore, a professor specialising in this field, described overconfidence as “the mother of all biases”.
That’s because it not only leads to over-trading but it can also exacerbate Action Bias and a range of other ‘Belief Perseverance’ issues spanning Confirmation Bias, Conservatism, Illusion of Control and Representativeness. While Moore wasn’t directly referencing the stock market, there is no shortage of evidence that this particular behavioural trap can be costly for investors who fall into it.
Studies show that people naturally tend to be overconfident, and it shows itself in a couple of ways:
It can be seen in people who think they know more than they actually do.
It can also be seen in people who think that they (and their abilities) are better than average (the ‘better-than-average effect’).
From the point of view of investing, there’s a lot of research that links overconfidence with underperformance. We’ve covered this subject in the past, and separately there are great summary articles by Timarr here and here.
The general thrust from the academic studies is that overconfidence leads to over-trading. And those who trade the most perform the worst. In addition, findings show that men (who are generally more overconfident than women) churn their portfolios more and, as a result, perform worse than women.
This was a key finding in a well known 2001 study by Brad Barber and Terry Odean. Their analysis of 35,000 trading accounts found that men trade more than women; the annual turnover rates of men were about 80%, while those of women were 50%. Both men and women earned poor returns as a result, but men performed worse.
They concluded: “Rational investors trade only if the expected gains exceed transaction costs. Overconfident investors overestimate the precision of their information and thereby the expected gains in trading. They may even trade when the true expected net gains are negative.”
Much of the early research was carried out over a decade ago, but a new study takes a further look at the impact of overconfidence, specifically in the UK. Here, the researchers used data based on more than 233,000 trading records of nearly 7,000 investors at a UK brokerage between August 2006 to November 2009. The aim was to find out whether the behaviour of investors who were prone to over-trading would be impacted by changes in market conditions.
Broadly, the analysis found that overconfident investors who were younger and traded via internet (rather than telephone) traded more frequently in positive market conditions.
It found that while men trade more than women overall, market returns didn’t have a significant influence on men’s trading. However, the researchers said there was a clear connection between men increasing their trading activity when markets are volatile. That supported theories that ‘sensation seeking’ and gambling are related to trading activity.
Finally, the study found that investors who receive financial advice trade more than those who don’t. The researchers said that investment advice made investors no less prone to overconfidence and sensation seeking in their trading.
This latest research reinforces the link between overconfidence and costly and unnecessary overtrading, which causes underperformance.
But while overconfidence can be costly, the solution isn’t to abandon confidence altogether. For Professor Don Moore, minimising confidence is actually “a recipe for perpetual doubt and inaction”. Instead he says the answer is to aim for a “Goldilocks zone” where rational beliefs meet reality.
He describes this as being built on beliefs that can be justified by evidence and honest self-examination: “It is not always easy to find this narrow path; it takes honest self-reflection, level-headed analysis, and the courage to resist wishful thinking.”
The good news for investors, is that just being aware of the risks of overconfidence and the associated Belief Perseverance pitfalls, can put you on the path to overcoming them. As we’ve mentioned before in our behavioural investing articles, it’s often helpful to test assumptions and be willing to consider that an investment idea might be wrong, so here are a few ideas:
Constantly challenge assumptions about a stock
Keep a trading journal of investment decisions and reasoning
Play devil’s advocate with investment ideas
Listen to people that disagree
Seek out contrary views and evidence that an investment case has changed
Be objective
For more on overconfidence, there’s a great article by Tom Firth here.
*Thanks to @miserlyinvestor for highlighting this.
About Ben Hobson
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Great article. Thank you. Currently reading David Dreman: Contrarian Investment Stratégies which is excellent and has a lot to say on this area.
One queston can you/someone explain what is meant by
“annual turnover rates of men were about 80%,”.
Does it mean that men only held 20% of their investments for more than 12 months?
Thank you.
It can do.You can use it to think independently of other people,but still listen to conflicting opinions [and try to pick holes in them privately].
“The general thrust from the academic studies is that overconfidence leads to over-trading.”
I cannot quite see from the article where the link is demonstrated between over-confidence and over trading.
It feels potentially a bit counter-intuitive. If we are very confident in our buys are we not likely to hold onto them too long? If we are easily swayed by good or bad news, or positive or negative commentary, because we are not confident in our own judgement are we not more likely to buy and sell more frequently based on that news or commentary.
I can see that being over confident in our own abilities can lead to under performance as we are just not as good at evaluating what to buy and sell as we think we are and less open to other information and views. So that’s fine.
I can see that trading too often leads to under performance due to increased costs and a likelihood of not timing trades very well.
I’m just struggling to see that over confidence causes over trading. Could it not also be the case that over confidence leads to trading too little?
Hello Ben, Thank you for your article. Over confidence feeding to overtrading cost me a lot of money in 2010.
Paradoxically I find that under confidence is just as deadly and also leads to a tendency to over trade ("this is not good enough, something must be done!").
In addition to your excellent tips, a technique I have found useful is to score out of ten and write down each week how confident I am feeling. If I go below 4 or above 6 I know I am in danger of over trading. When that happens (it's most of the time!) I try extra hard to do nothing or at the very least raise my standards of rational analysis and desist from following hunches.
Hello Graham, As someone who firmly believes that extreme levels of confidence have negatively affected my investment performance I will have a crack at answering your question.
Each piece of information I read is an opportunity to form an opinion, and if that opinion is strong enough, to follow through and trade. If I am over confident then I tend to place too much weight on my own opinion (either vs opposing opinions or vs no alternative analysis), and that inflated weighting can then cause me to place a trade where I otherwise wouldn't have. In the same situation, if I was less confident I may still have the same view but not be so sure of it and therefore not get as far as actually placing a trade.
Another bad thing about over confidence is it makes me lazy as I feel there is no need to do the hard background research because I already know the answer - I appreciate that's not an over trading side effect of confidence but still a bad consequence.
Hi kando,
Without wishing to patronise, I suggest you think about your objectives.
Are you trying to "make a quick buck" or investing for the long term? The former is fraught with danger and more akin to gambling. If the latter, then consider that markets always go up and down. There are good years and bad years. I don't know anyone who can predict them consistently and accurately - though plenty claim they can. Being invested isn't an all or nothing decision. If you're worried that markets may be toppy, then maybe you'd be more comfortable taking some profits and freeing up some cash.
In my experience it's always wise to have some cash buffer, then if investments sell off excessively, you're in a position to take advantage of bargains. If that doesn't happen, the rest of your portfolio can sail on happily. The best of both worlds.
Cheers,
Mark B
Solid advice. Look at your 10 year, 5 year and 1 year horizons and invest appropriately. If your goal is to be up 97% over 10 years, then patience will guide that (non-linear) path. If you need 20% in a year, your looking for volatility, which works bi-directionally.
Investors rarely associate melt-ups with volatility, since it is working in their favor.
I'm nervous about staying in the market but even more nervous about getting out. What do you do with your money? Put it in the bank and lose money due to inflation? My advice to anyone at this point, is not to buy a company that needs, or expects to need, money.
I understand your predicament Alan. I am wondering just when a market correction will come and what will trigger it. Bond yields rising is getting a quiet mention here and there and is not good for share prices generally. There are many investors now who won't have experienced a market correction nevermind a bear market. Timing is near impossible to get the most out of our investments and we will all have our own time horizons; some will be able to take a longer term view than others due to their own personal circumstances. Obviously investing in strong companies with strong fundamentals, that are more likely to see out tough times is key and staying away from highly speculative companies. Personally, I won't invest in any company that is not making a profit. Additionally keep ones portfolio under review but try not to take premature action based on ones gut feelings (not easy from personal experience).
Aside from that, you ask what do we do with our money when we are feeling nervous about the markets and putting money in the bank loses us money due to inflation and very low interest rates. Well, I would look at paying off any personal debt if possible. Perhaps look to pay down or pay off any mortgage, thus reducing/eliminating interest charges. Just my opinion and there will be plenty of others.
I cannot quite see from the article where the link is demonstrated between over-confidence and over trading
It isn't, but it's in the underlying academic research. The key finding of Odean and Barber was that over-trading led to worse returns, and that over-trading was associated with overconfidence. In fact, to be specific, what they showed was that the stocks that investors sold outperformed the ones that they bought. Most investors would have been better off not trading at all.
Of course, it's possible that overconfidence is implicated in under-trading as well, but the research hasn't shown that. Although, from memory, I can't remember any studies that have looked for this. However, there is a thing called the disposition effect, which is associated with loss aversion. What it shows is that people preferentially sell their winners over their losers.
The theory behind this is that people hate taking a loss, so they sell winners to lock in gains and they keep winners in the hope of making their money back. Unfortunately winners tend - on average - to keep on winning and losers tend - on average - to keep on losing. So it's quite common to see people keep their losing stocks, but that's not specifically over-confidence, it's simply a hatred of seeing red ink.
Of course, all of these biases are probably linked. We don't know how exactly to tease them apart but I think the research would broadly support Ben's article - overconfidence tends to lead to over-trading rather than under-trading. People who hold onto stocks too long are usually suffering from some other bias .
timarr
yes being an introvert helps, warren buffett spends his time reading alone and thinking for himself, he does talk to charlie munger but thats cause munger is very clever. a good time to buy shares is when the stockmarket has gone down 5 or 10 % then buy great companies that are saying profits are going to be ahead of expectations, avoid companies that have problems, its all about growth but get ready to sell if they come out with bad news, be really careful and sceptical and spread your risk, never ever have more than 10% of your money in one company, good luck.
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Brilliant article and study. I’ve always wondered if having an introverted personality gives me an advantage, over a trader whom may be an extrovert ?