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.

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Dealing with behavioral biases

Parag Parikh
Human thought processes are an amalgam of experience, intuition and rationality. Our actions are usually based on the belief that we know what is good for us. However, many times those actions are based on impulses which may actually be detrimental to us in the long run. Also, since the feedback mechanism is often not instantaneous, we bear the consequences of our actions much later. By that time it may be too late to remedy the situation. This behavioral tendency is visible in every aspect of our lives be it education, health, money, relationships etc.

While academics steadfastly cling to the ephemeral notion of “Rational Man”, there is an irrefutable and growing body of evidence contradicting this. If humans were truly rational, then all of them would have behaved in a very similar manner. For instance, the traditional regimented route to success is : Finish your schooling, go to a “reputed” college, pursue a “safe” degree and get a “good’ job, which until recently meant either a doctor, engineer or lawyer.

However, over the years, an increasing number of students have chosen to go on the road less travelled and guided by their heart, have chosen off-beat courses such as wild-life photography, linguistics, etc. At the outset, virtually no one knows whether they will be successful or not. However, that does not deter them from putting in their best effort. My point is, even in a relatively unadventurous field such as formal education, many a time, the heart rules the head.

Coming back to the core subject of this article, whenever clients visit advisors, they expect us to solve all their financial problems and want us to assist them in attaining all their financial aspirations. However, I have observed that they display several cognitive and emotional behavioral biases while interacting with us. Here are a few of them:

Optimism Bias:
Many a time, clients visit us after they have experienced some kind of financial trouble. It could be related to debt burden, the tendency to over-spend, a job loss etc. At that point they are overly optimistic about our ability to provide quick-fix solutions and immediately get them back on track. Often they fail to comprehend that it takes a joint effort on the part of both, client and advisor, to emerge out of the rut.

Representative Bias:

Many times clients compare us to their family doctor and expect that we will provide them with the equivalent of tablets which will help them recover in a few days. While, it is true that there are some parallels between the two professions, we are more adept at providing solutions which will help you in the long-term rather than the short-term. In other words, feedback mechanisms are often not instant, in our case. On a lighter note, I think it would be better if they compared us with to dieticians rather than cosmetic surgeons.

Sunk Cost Fallacy:

Clients persist with products which are unsuitable for them, simply because they have paid for them. Investment oriented insurance policies are good examples. The policies that they currently own may provide a low life cover and may be opaque & difficult to understand, Yet they are reluctant to surrender them, despite us pointing out better options. This is because they have already paid the premium for the past few years. Consequently, they are unwilling to bear any surrender-related losses, even if rationally they should be agreeing with our contention that in the long run it would be costlier to continue with the policy.

Confirmation Bias:

Often, certain long-standing beliefs have already ossified in clients’ minds when they approach us and it is difficult to suggest something which is contrary to these. For instance, if we suggest increasing equity exposure to an avowed debt investor, he may diligently point out all recent instances when the equity market has crashed. At the same time, he will not accord any weightage to the stellar cumulative performance of the stockmarket over the past two decades or so.

In other words, he will cling on to examples which fortify his belief that stocks are risky and conveniently ignore the ones which disprove this belief. To such people I cite several examples of companies reneging on their debt obligations.

Bandwagon Effect:

Everyone is more bothered about what the others are investing in rather than researching which product suits them the most. For instance, over the past one year, when Fixed Maturity Plans (FMPs) were in vogue, many of our clients were keen on opting for one year FMPs merely because some acquaintance or the other had done so.

This included clients who needed to utilise the same money within the next six months and for whom the illiquidity of the FMP was a big negative. It took a monumental effort to make them jettison this idea and convince them to park their capital in short term debt funds.

While there are many more such biases, the moot point is that while dealing with humans (and especially on a touchy subject like their finances), advisors must treat irrationality as “par-for-the-course” and not be surprised at anything that confronts them. This is more art than science. That is where experienced advisors score over the rookies who merely go by what their courseware states.

 

The ‘Onion Phenomenon’

 

 

 

Jayant Pai |  jayant@ppfas.com

You may remember that onions had hit a price of Rs. 70 per kg. during the first quarter of 2011. As they became more and more unaffordable, consumption fell steadily. The ensuing hue & cry and the fears of a political backlash motivated the powers-that-be to act swiftly. Consequently, within a few months, the prices were down considerably.  Continue reading

Envy: An (Un) necessary evil

Warren Buffett has apparently said in jest that out of the seven deadly sins, envy is the worst….because at least we enjoy while committing the other six sins. In case of envy it is only pain and no pleasure.

Despite this, I notice that envy is widespread in our society. Here are a two instances:

  • A client of mine met me last week. I noticed that he was not his usual chirpy self. When I inquired about the reason for his despondency, he explained that he was perturbed to note that while his Portfolio Management Scheme (PMS) Account with our firm had given him a return of 12% over the past year (no mean feat, considering the the broad indices were actually down by 17%). It perplexed me that instead of being ecstatic he was downcast but I soon knew why. Apparently, his friend had invested in another PMS account which also invested in Gold Exchange Traded Funds. Hence his friend had earned a return of 21% on his investment, which apparently gave him bragging rights over my client.
  • Every year once the annual bonus is distributed among colleagues at my company, I always notice a few glum faces. In most cases, they are not glum because they feel shortchanged, but are dejected because a few of their colleagues have received slightly more than them.

How do we deal with this debilitating feeling? While I do not profess to be a psychologist or psychiatrist, here are a few options that work for me. Continue reading