Overconfidence comes before the fall

June 13, 2018

It is the self-image that causes the problem

He called himself “Fabulous Fab”:  In 2014, investment banker Fabrice Tourre, the unrepentant face of the global financial crisis, went on trial in New York. Seven years earlier, he had created “Abacus”, a highly complex basket of mortgage-backed securities for Goldman Sachs. Tourre was found guilty of having been intentionally deceptive in marketing “Abacus”, which was in fact worthless, to professional investors including IKB, a Düsseldorf-based bank that the German government had to bail out by giving it a nine-figure cash injection.

Picture of the wall street bull statue
Investment banker Fabrice Tourre went on trial in New York, because overconfidence pushed him to be intentionally deceptive in marketing "Abacus". Photo © CC0 Licence

The case of Fabrice Tourre impressively illustrates that overconfidence comes before a fall. Overconfidence is the tendency to think one's abilities, skills and knowledge are exceptionally good and better than is actually true. Speculators quite frequently labor under this psychological distortion. They fail to see risks and believe to be in control. If they win in playing the stock market, they say it is because they are particularly literate when it comes to finance. If they lose, however, they often blame it on factors beyond their control: a difficult market environment, negative media coverage, etc. This type of behavior causes people to become inherently overconfident.

Frequently, the phenomenon of overconfidence is due to what is known as “self-serving attribution bias”, that is people's tendency to attribute positive outcomes to their own performance and skills while blaming negative ones on others, the environments they are in or generally difficult conditions.

Stock selection and timing

Overconfidence is also the reason why a speculator is firmly convinced that he or she is backing the right horse—although he or she lacks comprehensive market knowledge, and irrespective of the fact that future developments are hard to predict. These people do not diversify enough; instead, they adopt a strategy known as “stock picking”, i.e. they invest a lot of money in only a few shares. Also, they believe to know exactly when best to buy or sell shares (“market timing”) and tend to both overlook risks and trade too frequently. The latter results in additional expenses and may be considered disadvantageous for that reason alone. From a capital-market point of view, though, trading has a significant advantage: It increases liquidity.

A man in a suit
Overconfident people tend to adopt the "stock-picking" strategy - investing a lot of money in only a few shares. Photo © CC0 Licence

People prone to overconfidence are likely to prefer active investment strategies over passive index funds, which are more diversified in nature. But: Frequently, it is simply impossible to predict how a share will perform in the future. Empirical research has shown for decades that, in the long run, the performance achieved by those who primarily embrace active forms of investment is less good than that of the index. Passive index funds are, therefore, very popular with investors: According to Morningstar, a rating agency, 2017 saw the total amount invested in index funds increase by a record 100 billion euro net to 670.5 billion euro.

There are some steps you can take to protect yourself against becoming overconfident: 1. Ask yourself: Why could the assumptions you make regarding your skills be wrong? 2. Get external feedback. This will help you see things and yourself in an unbiased manner.

Less is more

As far as specific investment behaviors are concerned, I can give you the following tips: 1. Diversify your investment portfolio by buying different stocks or funds, and do not engage in stock picking! 2. Invest in funds that are diverse in nature rather than industry-specific or country-specific funds. 3. Prefer passive funds (ideally global funds) over active ones! 4. Do not make a forced effort to optimize your timing!

This article was published in the Austrian business magazine GEWINN. Read the original article here (in German).

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