Overconfidence
By Paul Copeland
JUST OVER 30 YEARS AGO, Orange County, CA declared bankruptcy. Three thousand government employees ended up losing their jobs, and it was all because of one individual’s overconfidence. Robert Citron ran the county’s investments and did very well in the early 90s, betting on falling interest rates, but in less than a year the Federal Reserve raised rates from 3% to 6%. His fund lost $1.5 billion, and he ended up going to jail. He was overleveraged and too committed to his view of the world (that interest rates would fall). Interestingly, he was correct over the long term – interest rates fell back to 3% over the next few years and they continued to fall for the next 25 years. He could have been very successful had he not been wiped out. Instead, his story is a sad reminder of the proverb that pride comes before a fall.
Robert Citron is not alone among elite investors. There are several examples of hedge funds run by very smart people whose success led them to overestimate their abilities and ignore risks that eventually busted them. Long-Term Capital Management (LTCM), with two Nobel-Prize-winning-economists in charge, was one of the largest hedge fund failures. Tiger Management, Atticus Capital and Melvin Capital Management are a few others.
Overconfidence is not just a danger for the gifted and talented. It can hamper the rest of us too. It’s documented in areas as diverse as gambling, driving and IQ. A Wall Street Journal article after this past Superbowl discussed the optimism of sports bettors in beating the odds that are clearly disclosed (and not in their favor). The average sportsbook customer loses 7.5 cents on every dollar wagered. With the proliferation of online gambling, I’ve had to turn down young folks wanting to show me a “sure” way to make quick money.
People think they can beat the odds not only in the casino, but also on the roads. According to a survey by AAA, 73% of Americans believe they are better than the average driver. Several studies also show that people think they are smarter than they actually are, and if you’re male, be extra careful. An article in Psychology Today pointed out that overconfidence can be more common in men, referencing a study where 72% of the men vs 60% of the women surveyed believed they were more intelligent than the average person.
People also think they are better than the average investor. One survey found 21% of Americans believe they are very likely to become millionaires in the next 10 years. Another survey of 300 mutual fund managers showed 74% believed they were above average with almost all the remaining 26% believing they were average.
Investing overconfidence is boosted by several types of behavioral biases. Hindsight bias, confirmation bias, and illusion of control are all biases that can inflate confidence.
- Hindsight bias is the common tendency for people to believe past events were more predictable than they actually were. After the stock market crash in 2008, not a few investors said they knew it would happen (housing prices couldn’t go up forever, there was too much leverage, etc). But these same people were fully invested in stocks, indicating they weren’t so sure before the crash as they later believed.
- Confirmation bias is the tendency to look for information to support our existing view. Republicans watching Fox News and Democrats watching CNN is an easy example. I remember looking at both sites after Gross Domestic Product numbers were released. CNN’s headline was “US Economy is slowing”; Fox’s headline was “US fights off manufacturing woes, posts win on GDP.” Each site spun the same number to confirm the views of its audience.
- The illusion of control is a superstitious belief that we have greater control over events than we actually do. It explains my son’s shaking the dice harder and longer for the number he wants in our Risk board game, or me leaning this way and that to keep my bowling ball out of the gutter as it rolls down the lane. It’s the reason that my friend’s lucky Celtics hat must be worn anytime he’s watching a game.
There’s no shortage of predictions about what’s going to happen in the next few years and many folks seem quite confident in their predictions. As I’ve pointed out, our brains are wired for that confidence. We need to recognize this and allow for the fact that things could work out differently than we expect.
I believe Federal Reserve chairman Jerome Powell is an example to aspire to in this regard. His response earlier this year to a question on how the President’s policies will affect the economy was, “The range of possibilities is very, very long. I don’t want to speculate, as tempting as it is, because we really don’t know.”
Very well educated, highly accomplished, with years of experience, access to all the data, and power to influence interest rates – you’d think if someone could tell us what’s going to happen it would be Chairman Powell. But he’s smart enough to realize that the economy is both incredibly complex and shaped by unpredictable events.
It’s good to make predictions but hedge your bets, like Powell, rather than going all in like Citron. Keep in mind that putting all your eggs in one basket is risky, even if that basket is cash. Think about what can happen if inflation, interest rates, foreign relations, regulations, currency exchanges and stock markets don’t all go just as you expect.
At Trust Company of Vermont, most client objectives require diversification among stocks of quality wide-moat companies in different industries, as well as bonds with various maturities and cash. We’re confident that this time-tested approach allows flexibility in getting through the future unknowns.