Overconfidence & Attribution Bias

                                        

Dream road is littered with great ideas that were going to solve everything. Many proposals were so sure to be successful that money fell out of the sky to fund them. In sports, talent at times can be so dominant that any opposition is a futile. Remember when the New England Patriots were so dominant that the New York Giants had no chance in the SuperBowl?

I’ve learned to be rather quiet about absolute convictions. Loud conviction likes to make a mockery of its believers. How did Eli Manning make that throw? It was as if the gods of irony all agreed to make bumbling fools of the experts. It just goes to show how dangerous overconfidence can be. Overconfidence will have you ordering the championship cake before the first quarter starts...only to give it embarrassingly to the stadium security staff later that evening.

No one wants to believe they may be in their own way, especially when it comes to investing. Yet, research has shown there are several common biases that can cause an investor to make decisions based more on emotion, than on strategy or science. This can impair investment returns...and in some cases, a total loss of capital.

Overconfidence Bias

Overconfidence bias refers to an investor’s belief that market returns are attributed to their own personal skill and decision making ability. They conveniently believe this when their investments are doing well. But market decline has nothing to do with them. Declines are the result of external market or environmental factors. In simplest terms, overconfidence bias suggests that an investor is wildly over assessing their own skill.

The Review of Financial Studies in 2006, written by Statman, Thorley and Vorkink, looked into
overconfidence bias, its effects on individual returns, and portfolio turnover for the individual investor. The study’s findings point to a positive correlation between market turnover within a portfolio, and delayed market returns; both supportive of the overconfidence theory.

One of the most interesting findings, with regards to this behavioral bias, is that investor confidence levels do not decline with duration. Common sense would seem to suggest that an investor would learn more about their own personal investment capabilities over time, causing them to modify behavior or accurately adjust confidence levels to reflect their performance...apparently not. Instead, most investors tend to ignore or conveniently forget damaging mistakes, poor security selections or delayed decisions. This supports the deception that undesirable outcomes were caused by external factors, and not by an internal faux pas. While confidence in investing can be considered an advantage, overconfidence can cause investors to miss the opportunity to learn from past failures, and make appropriate adjustments going forward.

Attribution Bias

While many investors invest entirely on emotion, others accumulate positions on the opposite spectrum, entirely on “specialized knowledge” or even technical analysis. Attribution bias is widely studied within the social psychology context, and deals with incomplete evaluations based on incomplete evidence. For the investor, the application refers to a tendency, for example, to select securities based solely on models or the quantitative data one is most familiar with. Negative indications are ignored completely. In other words, you see what you want to see while casting away everything that does not support your pre-determined decision.

Back to the Super Bowl – The heavily favored New England Patriots had their quarterback sacked more in 3 quarters than in any game the prior 5 years...shouldn’t they consider making an offensive strategy change? They continue along “on plan”, they simply refuse to do it because their pre-game clipboard indicates that they will win in the end. In the case of technical analysis, investors can focus on future behavior by studying current and past patterns in stock trading volume, price and other quantitative metrics. Although, the footprints of money are very revealing, these footprints can be manipulated to prove any pre-existing conviction.

Hindsight Bias

Hindsight bias is something almost everyone practices in both their personal and investment lives. Once something has passed, an event or a situation, we tell ourselves that we knew what was going on the entire time. Or, we convince ourselves that while the situation was spiraling downward, we were aware of the expected outcome, had it under control, and permitted it to take place. 

The danger in hindsight bias, with regards to investing, is that it can cause an investor to lose substantial portions of their portfolio because of “reality denial.” What has happened in the past is vital for future guidance, to the extent we can admit we didn’t know what we didn’t know. Keeping a journal or accurate notes of investment decisions and accompanying logic, will help an investor avoid the same mistakes when they present themselves again. Such honesty can also provide conviction to make the same strong investment decisions when the opportunities again surface in similar fashion.

Lift the Hood

Although both are inevitable, it is never easy to lose money or accept mental errors. The ability to recognize mistakes so that modifications in behavior can occur is a mature lesson for a long-term investor. The secret is, becoming wise enough soon enough so it can do you some good. When a mistake is made, it is more beneficial for the investor to turn around, lift the hood of the future and start fixing things. Too much time on the past, possessing hindsight bias, and dwelling on missteps is not productive for building portfolios.

How can you prevent yourself from making these common investment errors? The first step is to become more self-aware. If you are not able to objectively look at your own behavior, you will be unable to see baseless patterns in your decision making process that can damage your portfolio. Self-awareness coupled with sound strategy, a touch of knowledge, and a full-cup of patience is a southern-style recipe for successful investing. 

 

For more information on BEHAVIORAL FINANCE, read these related articles:

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