Don't Be So Sure
Decision-making fascinates me. Why do people choose one course of action over another? What influences decisions? Why do highly intelligent, rational people make suboptimal decisions? Behavioral Finance emerged in the late 70’s with Amos Tversky and Daniel Kahneman’s release of “Prospect Theory: A Study of Decision Making Under Risk”. Among other things, their paper challenged the long-standing economic assertion that humans will always behave rationally (devoid of emotion) and instead looks at how people actually act. Since then, scholars have tried to understand the gap between theoretical decision making and actual behavior. A few highlights from this field of research:
The same question framed different ways will yield very different results. One study showed when MDs told patients they have a 90% chance of surviving a particular surgery, 82% of the patients opted to have it; when they told patients they have a 10% chance of dying from the same surgery, 54% opted to have it. Same surgery, same probability, different presentation of the data, very different outcomes.
People think and feel differently about gains and losses; they are risk-seeking when it comes to losses but risk-averse in the domain of gains. Simply, when given choices, most people prefer a sure thing but will take risk to avoid losing money, even at the risk of a greater loss. Emotions aren’t symmetrical; the pain of a $1,000 loss overwhelms the pleasure of a $1,000 gain.
People are very willing to commit to doing the right thing; they just aren’t willing to do it today. Getting in shape (and the subsequent gym membership), saving for retirement, and diets are all illustrations. I’ll do it…but I’ll start tomorrow.
People are overconfident -- they repeatedly overestimate their own abilities. The rest of this blog is devoted to this bias.
As a simple illustration of how we evaluate ourselves, I have asked large audiences to rate their automobile driving abilities on the following scale:
- Above Average
- Below Average
- I Uber
The results are mind-boggling. 75-80% of respondents rate their driving abilities as above average or better. This math troubles me – either I have had the best drivers from all over the United States attend my presentations OR people have unwarranted faith in their driving abilities. Studies have shown that we would see similar results if we asked people to rate their decision-making, negotiating and portfolio management abilities.
Scholars have looked at the implications of overconfidence and it turns out this bias has portfolio implications. Dr. Terrance Odean at the Haas School of Business at the University of California, Berkeley has conducted extensive research on this subject. In “Boys Will Be Boys: Gender, Overconfidence and Common Stock Investment,” he looked at 35,000 households over a five-year period and found that men are far more confident in their own stock-picking abilities than women. In his study, he discovered that single men trade 67% more frequently than single women…and subsequently underperformed them by 1.4% annually. The performance differential makes a substantial dent in wealth accumulation. Also of note, Dr Odean found that, “men lower their returns more than women because the trade more, not because their security selections are worse.”
My message to the wealth managers in Chicago was (and is) to beware of hubris. It can and will affect your strategy. Over the fifteen year period ending 12/31/16, 92% of US Large Cap Equity Funds, 95% of US Mid Cap Equity Funds, and 93% of Small Cap Equity Funds underperformed their respective S&P benchmarks (to dig further into this data, and you should, click here: SPIVA Results).
The market is filled with highly intelligent people, and the vast majority are trying to do the right thing for their clients. The data on the lack of success for active managers is so conclusive that there has to be a behavioral component to those pursuing these higher-turnover, higher-cost strategies -- there is simply no other explanation. While economics likely play some role here, it’s very possible that overconfidence contributes to the wealth management industry’s commitment to stock-picking strategies with such dreary track records.
The field of finance is filled with portfolio managers, analysts and advisors with pristine pedigrees; there is no shortage of Ivy League diplomas hanging in Wall Street offices. These people are brilliant and the market is full of them; however, these bright minds ARE the market (which is why it is so hard to outperform.) From day one of preschool, they haven’t EVER been average, they’ve never thought of themselves as average, and they still don’t…and that makes a difference in the strategies they employ.
In “When All Traders Are Above Average”(1), Dr. Odean found investors with a high degree of confidence:
- Trade more frequently – they are more confident in each position;
- Earn less – this goes hand-in-hand with trading frequency; more trades mean more transaction costs, more taxes and more drag on returns.
- Underdiversify – there is no need to buy a lot of positions when you are “sure” about the few that you hold;
- Volatility increases – this closely related to the number of positions; fewer positions leads to more volatility and riskier portfolios;
In summary, Dr Odean found that highly confident investors trade more, earn less, and incur more risk. This is a lethal (and expensive) combination for clients.
Hubris could lead advisors to conclude that investing in an index is too simple. It would be easy to fall prey to: “I understand the data. Outperforming the market is really hard. You can’t do it, others can’t do it but I can.” Many clients have been successful in business and are susceptible to the exact same overconfidence bias: “Your Advisor can’t outperform but I’ve always surrounded myself with the best…and mine will.” According to Moody’s, over 72% of publicly traded assets are actively managed. This suggests that these investors believe (or have been led to believe) that their portfolios will outperform their respective benchmarks after all fees and taxes. That’s a lot of wealth chasing strategies where success has been so elusive. The evidence suggests that by accepting benchmark returns, portfolios would have found themselves in the top 5-8% of similar funds looking back over the last fifteen years. While there is no guarantee history will repeat itself, lower fees and taxes tilt the odds in the investor’s favor…and that gives me a lot of confidence.
We want our cardiologist, our surgeon, and our quarterback to be teeming with self-confidence but the evidence suggests we want our financial experts to come a healthy dose of humility. It’s not intuitive that results have ended up being far above average by accepting what the benchmarks give us rather than trying to predict short-term market movements and creating complex, expensive portfolios.
As the famous investor, Benjamin Graham, so eloquently said, “The worst enemy of the investor is likely himself.” Be humble. Be better.
(1) Odean, 1998, Journal of Finance