On overconfidence, optimism and risk…
But when things are going well, investors typically exhibit overconfidence about their prospects. The undue confidence in their own abilities leads them to underplay (or ignore) the risks that they are taking.
Excessive optimism helps explain the popularity of the stocks-for-the-long-run doctrine. The pseudo-factual statement that stocks always succeed in the long run provides an overconfident investor with more grist for the optimistic mill. To understand how easily investors slide into overconfident patterns, it’s worth knowing how common overconfident behavior is in general. Research has shown, for example, that people tend to rank themselves above-average on just about all favorable traits. Overconfidence extends beyond investment skill to driving ability, a sense of humor, and even expected longevity. In one often-cited example, when American students were asked to rate their own driving safety, more than three-fourths believed they were in the top third of the group.
Overconfidence may get cultural reinforcement too-an international comparison of the math achievement of young pupils around the world placed U.S. students below the 10 highest-scoring countries, yet the same American youngsters ranked near the top on their confidence in their ability to do math.
You may recognize this as the Lake Wobegon effect, where, as Garrison Keillor’s satire would have it, “the women are strong, the men are good-looking and all the children are above average.”
Common as it is, overconfidence is not universal. There is evidence, for example, that women are less confident-and more risk averse-in their investment behavior than men. This difference probably holds in other realms as well-at least one study, for instance, has shown that women underestimate their own intelligence scores whereas men consistently overestimate theirs.
In many cases, what looks like risk-taking is not courage at all, it’s just unrealistic optimism. Courage is willingness to take risk once you know the odds. Optimistic overconfidence means you are taking the risk because you don’t know the odds. It’s a big difference.
Optimism can be a great motivator. It helps especially when it comes to implementing plans. Although optimism is healthy, however, it’s not always appropriate. You would not want rose-colored glasses on a financial advisor, for instance.
On the illusion of control…
First, there is the confidence that flows from a sense of control-whether real or imagined. Abundant evidence suggests that people do feel more secure when they believe they are in control-even when they plainly are not. There are travelers, for example, who fear flying, although they’re quite comfortable behind the wheel of a car. Statistically, they have it backwards-the odds of serious mishap on the highway greatly outweigh the risks of air travel. But on the road, they occupy the driver’s seat, and that seems to make all the psychological difference. The common global phenomenon of driver overconfidence may similarly stem from the illusion of control.
The problem is that illusions of control bring a false sense of mastery over risk.
On outperformance of stocks in the long run…
If you are building a dynasty for the ages and have boundless resources, then stocks for the long run could be the best possible game plan. Losses should not faze you then-you’ll never need to withdraw the money, and you’ll have the resources to withstand all bear markets.
But for the rest of us, an extremely long-run standard does not suit our finite assets or mortal lives. To recall the aphorism attributed to John Maynard Keynes, ” the market can stay irrational longer than you can stay solvent.”. As we’ve seen, target-date funds or other age-based strategies don’t solve the problem because they may be locking in big losses at just the moment when they are switching from stocks to bonds.
Markets rise and markets fall, but it is folly to assume that they’ll hit their best averages in perfect rhythm with your own explicit needs. Instead of placing your faith in the potential of an indefinitely long run, a more dependable choice is to focus on the needs of your one very particular run.
On risk tolerance…
Your ability to take risk is entirely different from how you feel about risk. Risk capacity is an objective measure that reflects how much money you can afford to lose, even in a worst case, without impairing your minimal goals. But how you feel about risk is subjective. It’s not necessarily tethered to rational thought. Your risk preference, or tolerance, reflects how willingly you expose yourself to loss in exchange for the possibility of gain.
On curbing your enthusiasm…
The third concern to bear in mind when investing in risky assets is human nature, and irrational behavior in particular.
In combating overconfidence and excessive optimism, it helps to have a straightforward plan and stick with it. That means avoiding excessive trading. Hyperactive buying and selling by individuals is costly. Not only do you rack up high transaction costs this way, but there is no evidence that anyone has the clairvoyance to time markets.