Beware of overconfidence when investing!
By: Julio Cacho, PhD & Juan Carlos Herrera
Confidence is a double-edged sword, at once an asset and a liability—especially when it comes in that extra-strength version called overconfidence. On the one hand, it appears that overconfidence can at times be our friend, and may even be an evolutionary advantage. Without it, human beings wouldn’t take the risks necessary for great progress. On the other hand, by blinding us to the long odds and high risks of certain activities, it can set us up for disappointment, or even disaster.
This paradox is the topic of a thought-provoking post in The Economist, based in part on a longer New Yorker article by Malcolm Gladwell. The upshot of both pieces is that there is a big difference between how overconfidence works in entrepreneurship (where it is often an asset) and how it works in investing (where it is almost always a liability).
The man who coined the term entrepreneur defined it as a “bearer of risk.” The best entrepreneurs are risk-takers, risk-seekers. Studies show that they are wired for risk; and the secret of that wiring is overconfidence. In one survey of almost 3,000 entrepreneurs, 81% believed they had at least a 70% chance of success—even though 75% of all new business fail to make it past five years.
The best investors, by contrast, are prudent and humble about risk. While a certain degree of risk cannot be avoided, what can be avoided are expensive mistakes. The entrepreneur can recover from mistakes and even failure in a variety of ways. The mathematics of bouncing back from investing mistakes is far more unforgiving. You need a 33% gain to recover from a 25% loss; a 50% loss requires a 100% gain.
Investors who get burned by overconfidence often make a false comparison between investing and gambling. One of the main subjects of Gladwell’s article is Jimmy Cayne, the former CEO of Bear Stearns, whose collapse helped trigger the 2008 financial crisis. Cayne is an expert bridge player, and was convinced his acumen at bridge would somehow translate into good judgment in the financial markets. He was wrong.
Why was he so wrong? Bridge, while a game of chance, is a closed system with knowable odds and knowable risks. If we make a mistake of overconfidence, we will pay for it immediately and, if we’re smart, adjust accordingly. The overconfidence of the other players at the table can’t harm us.
Investing is different. If the price of a stock we have bought soars, we easily confuse chance or an overheated market with skill. We tell ourselves we have a “hot hand.” As dangerous as our individual overconfidence is the overconfidence of the market itself. At the peak of a market bubble, investors collectively feel they can do no wrong. They end up buying high and, after the inevitable bursting of the bubble, selling low—even though they know they should do the opposite.
As Ben Graham wrote after the stock market crash of 1929, when the entire nation fell victim to a wave of overconfidence, investing “isn’t about beating others at their game. It’s about controlling yourself at your game.” And the most important rule in controlling your game is avoiding the temptation of overconfidence.