Chapter 3
I am absolutely certain (overconfidence, confirmation and availability)
A frequently overlooked aspect of investment is how we make decisions. Our decision making can carry with it important unconscious biases. Typically, this area of decision making is the final step in the investor’s development from beginner to good investor. Earlier stages are analysis, money/risk management and the development of an investment plan.
Good decision making features two key elements. The first element is fact finding. Most investment decisions will be more soundly based if we have uncovered all of the easily readily available facts. The internet has made this a great deal easier than it was twenty or thirty years ago. We can discover information more quickly and search many more possible sources. Increasingly we should be able to avoid the sick feeling in the pit of our stomach when an investment fails because there was something that was readily available, but that we did not take the time to find out about. However, the flood of information on the internet has two downsides:
• Doing the research takes time, which none of us has in abundance.
• Some information on the internet is of dubious quality or mere opinion. We must be ever more able to assess the value of what we read there.
The second element is having an appropriate level of confidence, or being well grounded in the limits of our knowledge. Clearly, we cannot operate as effective investors unless we have enough confidence in what we know and what we decide to do, so that we can reach the point where we are able to ‘pull the trigger’ on transactions.
However, this tends to be the minority and to apply most to raw beginners. Once we are past that stage, many of us fall into the overconfidence trap.
Overconfidence is a term coined by behavioural finance researchers to describe a particularly dangerous bias in our investing decision making. This bias is present when we are far more confident about our decisions than we should be.
Overconfidence afflicts beginners, other than those who actually lack confidence, more than it affects those with experience. This is because with experience comes greater humility about what we think we know. However, we are all overconfident about all kinds of things. When teaching this I often give this kind of quiz:
Answer the following 10 questions. All questions request a range, not a specific fact. Your answer should be a range where you are 90 per cent certain that the correct answer is within the range you give. In other words, your task is to estimate a range that is neither too narrow nor too wide. Write your answers in the spaces provided below each question.
1 Length of the coastline of mainland Australia in kilometres?
Low: High:
2 Number of English monarchs?
Low: High:
3 Number of countries in Africa?
Low: High:
4 Number of plays written by Shakespeare?
Low: High:
5 Age of Julius Caesar at death in years?
Low: High:
6 Number of naturally occurring chemical elements in the periodic table?
Low: High:
7 Number of species of eucalypt?
Low: High?
8 Year in which Martin Luther was born?
Low: High:
9 Length of the Large Hadron Collider beneath the Franco-Swiss border in metres?
Low: High:
10 Length of the Trans-Siberian Railway from Vladivostok to Moscow in kilometres?
Low: High:
When you have written in your answers, go to the end of the chapter and mark how many of the correct answers were within the range you estimated. This is how to interpret our score, which is to gauge our level of overconfidence:
• If nine of the answers were within our range it suggests that we exhibit little sign of overconfidence (1 per cent of the population).
• If only three to six of the answers were within our range it suggests that we exhibit a strong tendency to overconfidence (this is where most people fall).
Overconfidence is when we think we know more than we actually do. The more of our estimated ranges that were too narrow to include the provided answer, the more overconfident we tend to be about our level of knowledge of these facts.
The most pernicious manifestation of overconfidence is revealed when we are absolutely certain that we know something, but it is actually untrue. This means that we act on faulty knowledge, from which we have drawn wrong conclusions. Nevertheless, we act with great confidence because we are ignorant of our mistake. This can be very destructive to our wealth when it plays out in the context of investing.
Overconfidence, like most cognitive biases, is easier to see in other people than in ourselves. This suggests that the place to start in being aware of the overconfidence bias is to look for it in others. Some things to look out for include:
• investors seeking peer support for their stocks
• investors focusing on confirming evidence and dismissing or apparently ignoring disconfirming evidence about their stocks
• investors who are unwilling to listen to conflicting opinions, or who tend to discredit those who express doubts about their stock
• investors who are unwilling to consider any alternative stocks
• investors who are unwilling to weigh up a range of alternative stocks before deciding to buy
• investors who simply close their minds to rigorous analysis of their stocks.
These clues will help us tune in to overconfidence in others. Then we should ask ourselves if we have ever been subject to the same bias in the same or a similar situation in the past. This is difficult and will be a challenge to our self-image. After that, the difficult part is to try to see it in our behaviour in real time.
Nevertheless, overconfidence lurks more consistently in some situations than in others. One of the striking observations made by researchers is that we are most likely to tend to exhibit overconfidence when we try to estimate something that is difficult to estimate. Estimating the value of a stock is a good example.
In this context, to estimate can also mean to forecast something. Predicting next year’s earnings of a company, or the level of the market index in a year’s time, are other examples of investment activities where we need to be aware of the high risk of overconfidence. Forecasting is an area where overconfidence is common because we tend to deal with difficult or complex problems by looking for simple cause-and-effect relationships. This means that we have not understood the situation in depth. It can also very commonly mean that we are relying on simple correlation without having established that one factor causes the other.
Of course, where there is a direct and simple cause-and-effect relationship between two things, which is well documented, our certainty may be well justified. However, in investing we are dealing with an extremely complex system in which there are many parameters that are difficult to quantify. Moreover, the relationships between these factors vary dynamically over time and place. Indeed, forecasting the future is so difficult at any time that there is a good case to avoid the problem and deal with it in another way. I will revisit this in the strategies at the end of the chapter.
Research has also shown that we are more likely to exhibit overconfidence when we feel sure that we know something for certain, than when we realise that we are in an area which may be outside our field of knowledge. Indeed, the most dangerous tendency is to be absolutely certain about anything. It is when we are absolutely sure about something that we may often be wrong. People who exhibit low levels of overconfidence often assert that there are very few things about which they feel completely certain. They are always open to contrary evidence. Good decision making requires two things: getting our facts right and knowing the limits of the reliability of our knowledge. We should never assume anything without checking it first.
Not only does overconfidence not apply to everyone, it will apply pervasively in some situations and yet be unlikely to be generally manifested in others. There are four danger zones for overconfidence.
The first danger zone is complex and uncertain situations. Overconfidence tends to be strongly exhibited in most of us when accurate judgements of any kind are difficult to make because the situations are far from simple or because there is great uncertainty about outcomes. This has been discussed above with respect to choosing stocks and forecasting their performance. An important awareness method is to score decision situations on a scale of one to ten, with one being when accurate judgements are quite easy to make and ten being when accurate judgements are almost impossible to make. The closer the score is to ten, the more cautious we should be about our high risk of being wrong, even when we have made our best effort to be correct.
The second danger zone is general euphoria. Overconfidence tends to be everywhere around us and we ourselves are at greatest risk of overconfidence when general confidence in the community is very high. For investors, this will be in the last stages of a bull market or bubble. Everything around us screams that we have never had it so good and only a fool is not in there minting money. A good clue here is when it is difficult to find people with a contrary view or when those who do hold a contrary view are vilified or ignored. It does not mean that dissenters are always right. In fact, they will often be wrong. However, when everyone seems to hold a single common view of the markets, we should be questioning our own confidence. It is a time to be seeking out contrary views and assessing them with the aim of avoiding being caught up in the crowd, which is deluded by the careless belief that this time it is different. In this respect, my own motto is to beware of anyone, including myself, who is absolutely certain of anything. This is when I am most on guard as an investor and looking to take a contrary view or to position my investment portfolio in a very defensive manner.
The third danger zone is expertise. Overconfidence tends to be far more prevalent when we find ourselves dealing with issues that are outside our area of expertise. Think about how many times we have heard someone proclaiming clear and definite ideas about a simple and seemingly obvious solution to a problem in an area they know absolutely nothing about. This issue has been studied in students who had just sat for an examination. On exit from the exam, the students were asked to estimate their mark. At one end of the scale, the students who knew the least about the subject and therefore achieved the lowest marks had vastly overestimated their own actual mark. This overestimation declined as students knew more and achieved higher marks. At the opposite end of the scale, where there were students who knew the most about the subject and achieved the highest marks, their estimate of their own mark was quite close to their actual mark. In some cases their estimate was lower than the mark they actually achieved. This is a manifestation of the idea that the more we know, the more awareness we will have of how much we don’t know.
The fourth danger zone is hubris. In the previous danger zone, as we become expert about an issue, our overconfidence tends to decrease. However, overconfidence is a tricky bias. Experts in a subject are also prone to hubris. If an expert finds they are right more often than others are, or are right more consistently than other people, they can become very arrogant about their ability. This means they may become overconfident, even when in areas well outside their area of expertise. Overlaying this can be the pernicious influence of public adoration of experts who develop a good track record in an area and become gurus in the minds of the public.
In order to understand ourselves better with regard to overconfidence, it can be helpful to review the reasons why we ordinary human beings unconsciously develop the overconfidence bias.
The first reason that we all tend to be overconfident is the illusion of superiority. This has already been touched on in the discussion of the hubris danger zone. Most of us tend to naturally and unconsciously have some level of illusion about our own superiority. It is easy to see around us once we know to look for it. There are two main ways in which this illusion of superiority plays out.
The first is that we all tend to be unrealistically positive about our own abilities. We saw this when we looked at the exam results experiments. Only the very small group of genuine experts may largely avoid this one. Notice that I said genuine experts. In the total population they are a very small percentage. Genuine expertise status comes from objective testing, not their own judgement, which may be just the illusion in action. By the way, if you think you are a genuine expert in something, and therefore have superior judgement, be very careful that it is not an illusion. In fact, if you think you have superiority due to genuine expertise, then it is unlikely that you really are a genuine expert. Genuine experts always tend to doubt their own level of expertise.
The second way in which our illusion of superiority plays out is that we all tend to be unrealistic about our futures. This means we all tend to think we will do well, while others will struggle, even though there is no evidence to support such a belief. This can be seen in a simple experiment that has been repeated many times by academics, but can be replicated in any group that does not know why we are asking the question. Ask the group something simple, such as to write down how they rate themselves as car drivers relative to the rest of the group. Ask them to rate themselves as above average or below average. Every time this is done, way more than half the group will rate themselves as above the average for the group. However, objectively half of the group must be below average and only half can be above average. There is a lot more research along these lines using different questions in varied situations, always with the same result.
The best way to mitigate this illusion of superiority in ourselves is to bring to mind that half of any group cannot be above average, and that applies to us, so we should be on guard whenever we think we may be above average.
The second reason that we tend to be overconfident is the illusion of control. This illusion plays out all around us every day. Every time there is some misfortune, people look to attach blame to someone. It is rare these days for many of us to instinctively judge that some event might simply have been an accident. Most of us have a greater level of naïve belief that we can control or should be able to control random events than is warranted. This illusion of control comes from two strong tendencies in all of us.
Firstly, we like to think that we are in full control of our destiny — in other words, that we can totally plan and shape the kind of life we would like, or at least can do so more ably than most other people. One moment’s conscious thought should dispel that belief, because we are all at the mercy of fate in all its manifestations. Disease, war and recessions, for example, are generally outside our control. The clue here is conscious thought. The problem with these biases is that they operate at the level of unconscious thought and are reinforced by the same general beliefs, also unconscious, in all of those around us in our society.
Secondly, as already discussed, we all tend to have a strong belief in the superiority of our own decision-making ability relative to that of others. We also have an unconscious belief that we plan our lives better than other people do. This strongly reinforces our belief that we can control our own destiny and therefore builds our illusion of control.
One useful way to mitigate our illusion of control is to remind ourselves that accidents, or what the insurance industry terms Acts of God, do happen, and far more often than we care to admit because we are too busy looking for a scapegoat. Try to develop the habit of assuming misfortunes happened by chance unless there is incontrovertible evidence that someone was to blame. Likewise, in our own lives, be slow to assume that things we do that work out well were due to our good management and that we were able to make them happen, rather than simply giving much of the credit to our good fortune.
The third reason why we tend to be overconfident is bound up in our limited imagination. This is a big one in investing. Every investment we make will be driven by an assessment of a situation and what we think are all the possible scenarios that may play out going forward. Ideally, we would score those scenarios for the probability of their happening and for the magnitude of the profit, or severity of the loss, that would occur if they came to pass. However, as investors very few of us ever get anywhere near first base in this exercise. We all tend to imagine that our investment is a sure thing. This is partly hope at work in our minds, but far deeper down, at the unconscious level, we all tend to believe we have imagined all of the possible scenarios. The problem is that we are all very poor at this task. If you doubt me, just think how many times you have been genuinely surprised by the actual turn of events, which was way outside the possibilities you had imagined. It happens to me repeatedly and I have been working at overcoming it for years now.
Early in 2009 I was talking to an investor who had lost a lot of money in the global financial crisis because he had invested in speculative stocks. He told me that he never imagined the market could fall as far as it had in 2008. I looked at him and judged that he was in his seventies. So I asked him why he thought that when he had been around the last time it happened: in 1974. His answer was that he wasn’t watching then. His ability to imagine all of the possible things that could happen was limited by his lack of memory or knowledge of past experiences. Of course, limited imagination is difficult to overcome, but it can be done if we are prepared to work on it.
Reading history and taking the time to ruminate on situations helps, as does tapping the imaginations of other people who are not involved in our situation. Something that I like to do is to make a list of all the worst things that I think could happen. Then I make myself write down one even worse thing, no matter how unlikely I might instinctively feel that it could happen. I have done this a lot over the years. It helped me greatly 25 years ago. I had made a list of possible investment catastrophes, one of which was that the market fell 14 per cent in a day. This was the worst I could remember hearing about. It was on Wall Street in 1929. I am sure there have been others, maybe worse, but I did not know of them. Then I asked myself: what if it was twice a bad as that and the market fell 28 per cent in a day? I tried to imagine a cause. Perhaps a major war started. Then I started thinking about how I should structure and manage my stock investments for such a calamity. Moreover, I mentally rehearsed what response I should make to deal with it, so I did not go into shock and be so frozen by fear that I could neither think clearly nor act decisively. I had learned mental rehearsal playing sport. Of course, it happened in October 1987. I woke up one morning and Wall Street had fallen almost that much the day before and our market opened 25 per cent down on the night before. I was amazed how calm I was at the time: I knew what to do and carried out my plan to sell everything into the first rally and then wait for the situation to settle.
The fourth reason why we tend to be overconfident is called confirmation bias in behavioural finance research. In this chapter, I am looking at the overconfidence bias. However, this bias does not occur independently of other cognitive biases. Overconfidence is a product of the interaction of other biases that have been well researched by behavioural finance academics. One of the cognitive biases that play strongly into overconfidence is confirmation bias.
This is how confirmation bias works in investment. For some reason a stock comes to our attention. We might read a positive report about a company in the media, or someone gives us a tip. We take a quick look at the stock and it seems fine. We may have some recent savings to invest in the stock market, so we decide to buy the stock we read about but realise that we should do some thorough research on it first. At this point we may quite unconsciously employ one or both of two approaches to researching the stock.
The first approach we might use would be to ask some of our friends what they think. Some will profess ignorance, but some will be positive about the stock, with reasons, and others will be negative. With the positive ones we engage in a happy discussion, because it reinforces our belief in the stock. However, with the negative ones, we either disregard them quickly or enter into an argument with them about the negative points they suggest as a way to try to reinforce and thus confirm our existing belief. We look for confirmation and simply disregard or try to discredit uncomfortable contrary views.
The second approach we might use would be to seek out facts and expert opinion from stock analysts. Again, the common reaction is to quite unconsciously seek out and spend a lot of time on confirming evidence, but gloss over any disconfirming evidence or uncomfortable opinions that we come across. Moreover, there is also a strong tendency, when we come across evidence or opinions that might conflict with our preconceived opinion, to interpret it in such a way that it really supports our preconceived decision. We see this all around us in our lives if we are alert. When there is a news item that, in itself, is quite neutral, we will find that different people will use it to support opposing points of view or arguments.
Confirmation bias is very common in all of us. At the end of the chapter, I will suggest some strategies that are aimed directly at it. For the moment, whenever we find ourselves with a strong view about something, we need to try to stop ourselves from locking in on it as the only possibility. We will not find better choices unless we try to look for them. When we think there is only one obvious choice, it is a good idea to force ourselves to think of at least one possible alternative before we commit ourselves. It never ceases to amaze me how powerful this is when I make myself do it. My first choice no longer looks a certainty and I can make a better judgement.
Likewise, if it all looks rosy with no negatives, we have not yet started to look properly or ask the right questions. There is a story about a famous meeting of the General Motors executive team in which everyone agreed with the Chief Executive’s proposed action. So he sent them all away until they could come up with a list of possible negatives. One thing that good investors say consistently is that the decisions they spent the most time agonising over, and that were most difficult to make, were the decisions that turned out to have been their best ones. Investing is about assuming risk. When a situation is fairly certain, the likely profit will be small. However, when there is great uncertainty the profit can be very large if we get our decision right.
The fifth reason that we tend to be overconfident is commonly known as selective memory, which tends to be very insidious and affects most investors to a greater rather than lesser extent.
We all have a selective memory about investments we have made. This is how it works. We feel good about the investments that lead to big or at least good returns. These are the investments that we unconsciously want to remember. Moreover, they are the investments that we talk about to others. This repeated telling of the tales of our best investments also reinforces our memory of them.
On the other hand, we will make many investments that result in losses or very unsatisfactory returns. This is an inevitable part of investing, no matter how good we are at the craft. These are the investments that we unconsciously do not want to remember or talk about to others, partly to protect our ego. It is painful to think about them, or to talk about them, so we don’t and that leads to our generally forgetting about them.
The result is that we have a selective memory, which is full of our successes but has pushed our failures out of mind. Our memory is now totally unbalanced. Therefore we have a quite unrealistic idea of how good an investor we are. This reinforces the illusion of superiority and the illusion of control in particular.
There is a related aspect of selective memory in investing. Most of us do not keep good records. We do not track or have good knowledge of our own previous investment performance. Since what we recall well are our successes, and we put our failures out of mind, this typically means that we will tend to underestimate our downside risk, which opens us to taking bigger risks than we should, especially in being under-diversified in our portfolio because we overrate our stock-picking ability.
Fortunately, there is a really good strategy to combat selective memory, which I will explain at the end of the chapter.
Another aspect of overconfidence is the question of the certainty of our estimates as against the accuracy of our estimates. Academic researchers have had a field day with this one, finding it in spades in trained experts and ordinary people alike. The research has typically asked a series of questions. What was more important were the linked questions of how certain the subjects were about their answers. Since the questions had a definite factual answer, it was easy to compare certainty and accuracy of the answers. These were the typical results of the research:
• When subjects were 100 per cent certain of their answer, they tended to be accurate only 80 per cent of the time.
• When subjects were 90 per cent certain of their answer, they tended to be accurate only 75 per cent of the time.
• When subjects were 80 per cent certain of their answer, they tended to be accurate only 65 per cent of the time.
• And so on . . .
The results for this kind of experiment have consistently shown that our certainty always exceeds our accuracy, no matter what the test. This demonstrates our general tendency to overconfidence in almost any sphere. The research also showed how experts in the field in which they were questioned did not score significantly better than people who were not expert. This result behoves us to be very careful of overconfidence in areas in which we feel that we may have better than average knowledge.
Researchers also caution us about the illusion of knowledge, which is another aspect of why we all tend towards overconfidence. Academic researchers have found the illusion of knowledge to be very prevalent in both trained experts and ordinary people.
One famous experiment by Stuart Oskamp (‘Overconfidence in Case Study Judgments’, Journal of Consulting Psychology 29, no. 3, 1965) tested experienced clinicians, graduate students and undergraduates in a field of study. They were given some information from an actual case and asked to make a judgement based on it. At the same time they were asked how confident they were that their judgement was correct. Then, in three more stages, they were each time given more information and questioned again about their judgement and their confidence in it.
What came out of the research was surprising, in that there was little difference in the results between the experienced clinicians, the graduate students and the undergraduates. As the subjects were given more information, their confidence level rose strongly from just over 30 per cent in stage one to just over 50 per cent in stage four. However, the accuracy of their judgements, which was around 27 per cent in stage one, fell to around 23 per cent in stage two and improved only marginally in stages three and four to around 29 per cent. The general conclusion from this is that when we are given more information, we become more confident of our judgements, but our accuracy tends to hit a ceiling.
This experiment and many others like it suggest strongly that there is a common illusion among both experts and ordinary people that more information will increase the accuracy of their judgements.
The illusion that more information is better is intuitive to us all. When faced with a difficult decision, our natural instinct is to ask for, or seek out, more information because we feel this will make the decision easier. However, our intuition fails us because more information might well be poor information. In any case, even if the additional information is as good as, or even better than, the initial information, it may not assist us to make better judgements. What matters is not how much information we have, but knowing which are the important factors driving a situation. In other words, it is not the information itself, but what we do with it that matters. In short, more information usually increases our overconfidence, but not our judgement or decision-making skills.
Another very common contributor to overconfidence is another cognitive bias called the availability bias. I still remember the ‘eureka moment’ I experienced when I first learned about this one. It made so much sense to me in terms of something that I felt was there but that I had been unable to formulate a clear idea about.
Availability bias occurs because three kinds of situation make a very large impact on us and unconsciously cause us to make totally distorted judgements that are contrary to the principles of probability. The three kinds of situations that tend to immediately spring to mind, out of all proportion to how often the events occur are:
• if something has happened to us personally or to people very close to us
• if something was very shocking, or in some way graphic, and was repeatedly reported in the media
• if something happened recently, rather than some time ago.
These events are most available in our memory — hence the term availability bias. The problems with availability bias that lead to poor judgements are threefold:
1 Our sample size is too small. Because we are seeing only a small part of a bigger picture, we are unable to apply the principle of probability. Suppose someone asks us whether car travel or air travel is safer. To assess the probability of car or plane accidents, we must know the number of accidents for each form of travel and the number kilometres travelled by each of the means of transport. This will enable us to judge the probability of accidents in each case. However, plane accidents get very great media coverage, whereas most car accidents do not get coverage in the media. Therefore, most people think flying is more dangerous than car travel, when the facts indicate the reverse to be true by a very large margin.
2 We lack a sense of proportion. Because we bring to mind only the few incidents that were recent, very graphic or involved us personally, we consider them to be far more important than would be warranted if we had a wider knowledge of similar incidents. When we tell someone about one of these incidents, their reaction may be at odds with ours. This is because their recall of similar incidents is different and they are therefore seeing a different picture in their mind.
3 We do not stop to consider what the real probabilities are. After the attack on the World Trade Center in New York in 2001, many Americans were afraid to fly around the country and travelled long distances by car instead. Yet only four planes, out of approximately 14 000 flights, were hijacked on that day and there had been no similar incidents in the US for some years. The repeated graphic images in the media had literally brainwashed them. Even people who used probability in their professional lives were so affected that they did not stop to assess the real probability. Emotion had totally overwhelmed reason.
Summary
We all tend to be overconfident. We think this problem applies to others but not to us, yet that in itself is overconfidence. Overconfidence stems from our illusion of superiority; our naïve belief that we can control random events and that we plan better than other people; our limited imagination; confirmation bias in fact finding and decision making; our selective memory; our greater certainty about things than is warranted by the facts; the mistaken belief that more information necessarily improves our decisions; and finally, availability bias. This is a long list and emphasises just how pervasive overconfidence is in our lives, but especially in investing.
Having reviewed what overconfidence is, what causes it and what problems it creates, we can appreciate the need to work on overcoming it if we are to become effective investors.
Strategies
1 We should be very watchful that we are not making investment decisions based only on small data samples. There is an abundance of beliefs, both in fundamental analysis and especially in technical analysis, that have not been proven in the scientific and disciplined way that is widely demanded in other disciplines. We cannot test everything we might use, but a simple discipline that will help avoid the small sample problem is to do our best to answer these questions:
• How many times has this pattern or idea worked in the past?
• How many times has it failed to work?
We should try consciously to never accept anything as being true without knowing the full, statistically proven facts about when it has proved true and when it has proved false, and how many times. No matter how roughly we answer this question, just being aware of the need to ask it will tend to make us far more circumspect when using the pattern or idea. That will go some way to reducing our level of overconfidence.
2 One of my favourite and most powerful strategies is to consciously ensure that on any investment decision we examine both the positives and the negatives before forming our own view and acting on it. This is especially powerful when we find ourselves absolutely certain about buying a stock. We should never buy a stock unless we understand the reasons why someone would sell it to us. There are two ways to carry out this strategy.
The first is to set out the pros and cons. This is an ancient technique that everyone should have learned at school and never forgotten. Take a sheet of paper and draw a line down the centre. Head one side ‘Pros’ and the other side ‘Cons’. Then write down all the reasons we know on both sides. If we have a large number of reasons in favour of our decision and few or none at all against it, we have a problem of overconfidence. Our view is unbalanced and we are in grave danger of making a poor decision. We should force ourselves to think about the reasons why someone would choose to be on the other side of our proposed transaction. If we cannot figure out the reasons, we need to find someone who can assist us to see the other side. Only when the sheet is complete on both sides can we weigh it all up and we will make a far better decision most of the time. It may be that we quite often decide to do what we started out to do, but we just might catch the ones where we are overconfident through lack of research and thinking, which will save us from big losses.
The second is to seek a devil’s advocate. This term originates from the process by which popes in the Catholic Church went about deciding whether to make someone a saint. In short, a case in favour was presented. The Pope then appointed a canon lawyer, known as the Devil’s Advocate, to investigate and present a case against the proposed canonisation. As investors, we can adopt a similar method. When we find we can only see the arguments in favour of an investment, we might try to seek out someone who is able and willing to present the case against our proposed transaction. Once we have the case for and against, we can weigh up the arguments and come to a better decision.
The key idea in these two methods is to be a sceptic and to practise the methods known by the general term contrary thinking, where we take any generally accepted idea and try to disprove it. This will be most effective when everyone around us seems to believe that this time things will be different. Avoiding the pull of the crowd at these times can be very profitable for an investor. I will discuss this in more detail in part II of the book.
3 Cultivate and develop an awareness that quality is better than quantity. The idea here is to focus on what is important and don’t waste too much time and energy on the things that do not make a real difference in a decision. The way to apply this idea is to read and learn widely about both fundamental and technical analysis. Then identify which are the critical ratios in fundamental analysis for our type of investing. Likewise, identify which are the key charting ideas or mathematical indicators for our investing method. Then focus on them primarily. For example, momentum, RSI, Stochastic and MACD are all momentum oscillators. If we need a momentum oscillator in our investment method, we should test to find the one that works most comfortably with our method and use it.
The next step is not to just focus on one or a few stocks that we may happen to come across. That is another aspect of the small sample problem discussed earlier. Instead, apply our key fundamental and technical criteria to lots of opportunities and select the best of them to analyse in depth. The idea that I keep in mind here is never to fall in love with a stock that I know very well. In fact, I have trained myself to be more cautious with the familiar than with the unfamiliar in the universe of stocks available to me for investment.
4 Consider every critical aspect. This is a sub-set of the previous strategy in that the focus is on what is important or critical to the situation or stock. Once we have decided to look at a stock in depth, a useful technique is the well-known SWOT analysis (SWOT stands for Strengths, Weaknesses, Opportunities and Threats). It may be employed in analysing and assessing a specific investment. It is a method to make us look at every important influence on the business. For a good basic introduction to the technique see http://en.wikipedia.org/wiki/SWOT_analysis.
Once we have thought through the strengths, weaknesses, opportunities and threats in a business, we will likely make a better informed decision about investing in that business than just taking a stab in the dark on limited information and superficial thought. If it is difficult to come up with a clear view with any of the SWOT headings, the ideas under the second strategy may be usefully employed.
5 All good investors keep good records. Of particular importance is to measure our investment performance during the current year and over the many years that we invest. Calculating and continuing to monitor our rate of return will ground us better against the overconfidence that can develop from selective memory of our successes. We should at all times know our absolute return and also our relative return compared to our required return on capital and an appropriate market benchmark. For investors the most appropriate benchmark is a total return index (in Australia called an accumulation index), which assumes the reinvestment of dividends.
6 Another strong strategy for dealing with overconfidence from selective memory is also a great learning tool: I keep a journal or diary on every investment I make. In it I record what I knew when I decided to buy the stock. Then I record every decision I make. To avoid hindsight bias it is important to do this in real time, not after the event. When I finally sell a stock, I complete the journal by assessing my decisions and actions against my investment plan and draw any lessons from it.
7 I mentioned earlier that we are particularly prone to overconfidence when we are forecasting or predicting something. When we worry about the future, our natural instinct is to look for someone who can forecast the future. We are all unconsciously wired that way and it is reinforced by everyone around us. However, there is abundant research to show that the human race is very poor at predicting the future and forecasting most things.
There is an associated problem with forecasting, especially, but not only, when we make the forecast public. This is that confirmation bias swings into action with a vengeance. We protect our ego by seeking out only confirming evidence and ignoring or discrediting contrary evidence. We have lost our objectivity.
The way I deal with this is simple to explain but takes a while to become accustomed to:
• I set out my investment objectives and strategy.
• I analyse the condition of the market.
• I fine-tune my strategy for the market I am in.
• If the condition of the market changes, I adjust my strategy.
This is such a powerful philosophy that I recommend it to any investor who is looking to make a big improvement in what they do. I don’t waste my time reading or listening to forecasts and treat any I hear very sceptically using the contrary thinking principles discussed in part II.
This chapter was based on a presentation made to the ATAA National Conference in Brisbane in October 2010 and repeated at Dr Alexander Elder’s Pacific Traders’ Camps in Macau, China, in November 2010 and May 2012 under the title Mind Over Matter.
Answers to the quiz
1 Length of the coastline of mainland Australia: 35 877 km
2 Number of English monarchs: 66
3 Number of countries in Africa: 54
4 Number of plays written by Shakespeare: 37
5 Age of Julius Caesar at death: 55 years
6 Number of naturally occurring chemical elements in the periodic table: 98
7 Number of species of eucalypt: 734
8 Year in which Martin Luther was born 1483
9 Length of the Hadron Collider: 26.659 m
10 Length of the Trans-Siberian Railway from Vladivostok to Moscow: 9289 km