Behavioral Finance is the study of why we as investors do what we do. The key finding of relatively new field is not that we are irrational (which is no surprise), but rather that we tend to be irrational in predictable ways (i.e., when large numbers of investors face similar decisions amid uncertainty, we tend to behave in a similar way).
We’ve found that six of these tendencies (or biases) are major barriers to long-term investment success. These are overconfidence, confirmation basis, loss aversion, herding, regret aversion, and biased judgments. We’ll discuss them one at a time, starting with overconfidence, in this and subsequent quarterly letters.
Of the tendencies, perhaps the most pervasive is overconfidence in our beliefs and abilities. Research consistently shows that we overestimate our abilities in most areas.
Below are a few examples of studies that do a good job of illustrating that point:
- When drivers are asked to rate their competency in relation to the average driver, typically 80 to 90% rate themselves as more skillful and safer than the average driver.
- When college students are asked about likely future outcomes for themselves and their roommates, they consistently rate their likelihood of having successful careers, happy marriages and good health much higher than the roommates. The roommates were believed to be far more likely to become alcoholics, suffer illness and experience a variety of other unfavorable outcomes.
- In one well known study by Tom Peters, male adults were asked to rate themselves in terms of their ability get along with others. 100% of them ranked themselves in the top 50% (not one thought they were below average) and 25% believed that they were in the top 1% of the population.
- Even in areas like athletics, where overconfidence would seem more difficult, at least 60% of the people in the Peter’s study ranked themselves in the top 25% of athletes and only 6% believed that their athleticism was below average.
Daniel Kahneman, the author of another of my favorite books, argues that overconfidence bias is particularly strong among investors. His research shows that not only do we tend to be overconfident about their own knowledge and skill, but perhaps more importantly we dramatically underestimate risk and the role that chance plays in making investment decisions.
As with any problem, the first step is recognizing it. It is critical that we as investors (and especially we as Investment Advisors) realize that we are human and tend to be overconfident. Once we do this, we can embed systems within our investment process to help overcome that .