Investing with Overconfidence

Over confidence is a peculiar feature in humans which has sometimes made us do phenomenal things and also allowed us to make colossal mistakes. It is true that in order to do something totally remarkable & unique we need to have a high level of overconfidence in our ability to achieve. This overconfidence comes from our optimism to do something. Overconfidence in this context is very useful which tends to motivate us & keep pushing till we succeed. It is like Thomas Edison whose optimism to tinker with the light bulb & his overconfidence in his abilities to actually make it, led to a remarkable invention.

 

The dark side of overconfidence comes into picture when our overconfidence hurts us by blinding us to very obvious errors in judgements. It is like watching a Superman cartoon & going on the rooftop to see if we can fly too. Generally the dark side of overconfidence becomes obvious only in hindsight. But we need not be suckers to overconfidence all the time. Becoming aware of where we tend to be overconfident can protect us from making a rash decision.

 

In this phenomenal book Mastermind – How to think like Sherlock Holmes written by Maria Konnikova she uses the great fictional detective’s ability to solve tough criminal cases to explain how we can train our brain to become as sharp as Sherlock’s. In one chapter she mentions how even someone as sharp & mindful like Sherlock Holmes can fall prey to the dark side of Overconfidence. She lists four major instances where overconfidence has been most prevalent.

First: The Hard-Easy Effect
We tend to be overconfident when faced by a very difficult problem & we tend to be under confident when the problem is pretty easy. Most common errors in investing occur when we try to predict the future outcome of a particular business. We always have incomplete data, but that doesn’t stop us from making predictions. We never stop for a second to believe how difficult it is to actually know the future of anything, let alone a particular stock. We are not even sure what is going to happen in our own lives tomorrow, so how can we be so confident in predicting the outcome of a stock over a few year’s time? We still go ahead with great confidence with whatever knowledge we have or lack of it, to predict a nice trend for the business which of course matches with our biased view about it. Combine this overconfidence with lack of portfolio discipline, & we are surely tempting misfortune to strike by not protecting ourselves from the prediction not working.

 

Second: Overconfidence increases with familiarity
This is yet another dangerous form of overconfidence & requires great efforts to control. Imagine a situation where we read a very favourable article about a particular company’s future growth prospects. The article captures our imagination & we knew nothing about this company before we read the article. Now like a great detective we decide to uncover the evidence for the article’s conclusion by going through the company’s annual reports & other publicly available information. After reading a couple of year’s annual reports we might feel confident about understanding this company’s business. We become familiar & acquainted with what the company does. Remember we are already conditioned to believe that this company’s prospects are going to be great. All that happens here without any critical reasoning, is that we have found evidence about this company’s past growth. Using the hard-easy effect here, we tend to take a familiar concept & start to automatically forecast the company’s future prospects. Outcomes which otherwise are simple to ignore but when they occur to us in contexts which we are highly familiar with might lead us to believe that we can predict them.

 

Third: Overconfidence increases with the quantity of information
This is by far the most dangerous outcome of overconfidence. This works beautifully along with the Second bias of familiarity. In our quest for finding evidence we tend to search for whatever data we can find about the company. It is believed that Joseph Stalin once said, “Quantity has a Quality of its own”. Clearly he was not a financial analyst. Where it may be true for tangible things like money, goods produced, etc it is equally tricky when it comes to information. The quantity of information also makes us feel secured in our knowledge about a particular topic. It is important to know more about a business before deciding to invest money in it, but all information is not made alike. Some information is important while some information is just trivia & totally useless for critical reasoning.

 

Fourth: Overconfidence increases with action
Investing like any other activity is a habit driven task. When we are used to researching investment ideas & working on them, allocating money & sometimes even making good returns, we get used to the small steps which lead to the final outcome. For instance we know how to read an annual report, we learn to search for information in the obvious places, ask people around about a particular investment idea & so on. These steps involve making judgements about the investment idea, on the go. Every new piece of information forces us to make a judgement which will either fit the facts we have already seen or it won’t. Each judgement requires critical reasoning which gets sloppy when the Second & Third Biases of overconfidence are in full force. All our habitual actions make us believe that we have some magical ability to get this investment idea right by merely doing what we have always done. This creates a very obvious blind spot in our decision.

(This is a very common error faced by drivers who have driven regularly over several years. Now they feel overconfident about their ability to keep attention on the road & they start using their mobile phones while driving, or even stop wearing seat belts & the most dangerous, drink & drive.)

 

Now that I have sufficiently scared you with the perils of overconfidence lets take a look at how we can avoid decision making errors because of overconfidence.

 

Beware of our Overconfidence:
One of the best ways to tackle the wrong kind of overconfidence is to be consciously aware that we can get overconfident. The above mentioned 4 basic traits of overconfidence will serve as a guide to make us think about what we know, how we know it & how it must be used to reach a conclusion or a judgement.
As the legend goes, after Julius Caesar came back to Rome from winning major victories & conquering half of Europe, there was a ceremony called The Roman Triumph to publicly celebrate the achievements of the great commander. Caesar was rumoured to have appointed a slave whose only job was to stand behind Caesar. When everyone would be showering praises at the General the slave would inconspicuously lean & whisper these words into the General’s ear: “You’re just a man.” What a great way to avoid the trap of overconfidence by reminding himself of his mortality! The Author Maria Konnikova says in the book, ‘Even the best of us—especially the best of us—need a reminder of our fallibility and ability to deceive ourselves into a very confident blunder.’

 

Avoid Quick Judgements:
If there is any judgement worth making, it can be made later. There is no need to rush to conclusions just because we have to. We can postpone making any judgement & passively soak the inputs. This is easier said than done, because our mind races to judgements almost automatically. But with little bit of training & consciously stopping ourselves when we are about to make a judgement, we can avoid being judgemental too soon.

 

Force Critical Thinking:
Critical thinking is all about habit. It is the next step of avoiding quick judgements. This is a very convenient step to avoid making judgements by starting to think critically or question every bit of important data. Making scenarios & imagining possibilities of outcomes is also another form to encourage critical thinking.

 

Make a Logical Sequence of Data:
In the same way as all data is not made equal, it is also not laid out in a sequence. We can very easily understand the chronological sequence of events that have happened in the company’s past, but we have to deduce how various decisions have been made & in what order to make the company become what it is today. Some decisions can be a result of the management being lucky or they might have strategically thought & planned that decision. In order to understand the motivations & strategy behind the management’s decisions it is most important to form a logical sequence, after critically filtering the data in the previous step.

 

Try to Learn a New Angle:
There is always more than one way to look at something. In the same way we don’t have to accept our own views about a particular business. We can definitely incorporate more angles to look at the same thing. In stead of just relying on publicly published material about the company we also tap the company’s customers, dealers, distributors, ex-employees, current employees, journalists who have written about this company in the past & so on. All these elements will add new angles for us to put, what we already know, in a logical sequence.

 

It is true that we need a certain degree of overconfidence to identify a trend before other people can see it. It is necessary because otherwise we won’t act upon our convictions and miss the opportunity. Also this confidence is linked with our ability to accept some risk and demand some sort of margin of error before plunging into the decision. Overconfidence combined with a little fear & skepticism can become a very potent tool for investing.

 

Luck not only favours the prepared but also favours the bold.

 

By: Raunak Onkar

2 Comments

  1. Well, how do you distinguish between confidence and overconfidence? Meaning, reading annual reports, collecting data, etc, are done to increase confidence right?

  2. Hi Prashanth,

    Thanks for your comment.

    There is a difference between confidence & overconfidence in terms of price paid to buy a business. If you buy without a margin of safety & knowing that there is no margin of safety – that’s pure overconfidence.

    It’s a classic way to get sleepless nights.

Leave a Comment.