8 Jun 2016

Understanding investor behaviour: overconfidence and hindsight biases

Behavioural biases can wreak havoc in your portfolio. We explain overconfidence and hindsight bias and what to look out for when it comes to these psychological biases.

Snapshot

  • Overconfidence bias arises because people overestimate their abilities
  • Hindsight bias can lead us to unfairly evaluate investment managers
  • Luck is another important factor to be wary of when managing your own investments

In Understanding investor behaviour: loss aversion we explained how the behavioural bias ‘loss aversion’ can negatively impact an investment portfolio. In this article, we’ll look at overconfidence and hindsight biases and the problems they can cause for your long-term investment strategy.

What is overconfidence?

Overconfidence bias is best explained by the famous study that found over 90 per cent of drivers in Sweden consider themselves ‘above average’ (Svenson, 1981). In other words, the overconfidence bias arises because people overestimate their abilities. According to Daniel Kahneman (in ‘Thinking, fast and slow’) within the overconfidence bias lurks ‘hindsight bias’, which refers to the habit we humans have of reconstructing past information or beliefs in a way that allows us to believe we have known something all along (when we really haven’t). As they say, hindsight is 20/20.

Kahneman cites a study undertaken in 1972 when President Nixon visited China. Participants were interviewed before and after the trip and were asked to assign probabilities to various outcomes of the trip. For example, would the President meet with Mao Zedong? Interestingly, post the trip when the outcomes were known, the participants exaggerated the probability they had originally assigned to outcomes that had actually occurred.

Another great example is the naysayers who now say that they ‘knew’ the GFC was inevitable. Sure, some people thought there could be a crisis looming (and one or two may have actually called it, while calling various other events that didn’t happen) but most people did not ‘know’ the GFC would happen with any reasonable degree of certainty. They only say (overconfidently) they ‘knew’ because it has now actually happened.

So how do these psychological biases impact us as investors?

Portfolio impacts

There are a few things to look out for when it comes to overconfidence, hindsight bias and managing money.

1. Evaluate fairly with a robust framework

Hindsight bias can lead us to unfairly evaluate investment managers (or company management, when looking at individual companies). Instead of assessing the quality of a manager’s decisions based on their process, people and intellectual inputs, it’s easy to simply focus on the outcome, normally in the form of investment returns. But an Australian study done for ASIC found that good past performance is a poor indicator of future performance.

You need to make sure you’ve selected a manager based on more than their performance outcomes. Look carefully at: their process; the team they have in place; the risks they are willing to take; and if they approach investing with a consistent philosophy through time (in other words, they don’t change their spots when it suits them). Be clear as to how you’ve evaluated them as they will have periods of underperformance (we’ll explain shortly why it pays to stay the course).

It’s also worth considering whether some outcomes have been just plain lucky for an investment manager who has taken on irresponsible risks. Assessing managers purely on their investment returns and not understanding exactly how they were generated can be a dangerous game.

2. Don’t chase past winners

It’s human nature to want to back the best performing manager or a company with a strong share price. It’s easy to look at past performance and extrapolate that to the future and make a switch. Perhaps you convince yourself that you ‘knew it all along’. ‘Of course Magellan was going to outperform Platinum this year. They are such a better manager and I need to sell out of Platinum now.’

Switches like this will almost inevitably be done at the wrong time and incur unnecessary transaction costs. There’s compelling evidence to suggest that it’s expensive to be an investor who chases returns and switches between investments or funds. A study of US mutual funds between 1991 and 2013 found that poor trade timing costs investors on average 2 per cent per annum. The returns generated from simply ‘buying and holding’ were higher across all strategies as shown in Table 1.

3. Know your limits to doing it yourself

Overconfidence bias can lead people to think they can do better themselves. Perhaps you can, but it’s important to recognise your limitations – whether that be time, resources or experience. Let’s look at the case of investing in international shares either directly or through a managed fund.

It’s tempting to look at Platinum International Fund’s 12 month return (down 4.8 per cent compared to the benchmark down 2.5 per cent as at 30 April 2016) and conclude you could have produced a better return. It’s easy to lose sight of the fact that since inception Platinum have generated a return of 12.5 per cent per annum, beating their benchmark by over 6.5 per cent per annum (as at 30 April 2016). Not an easy feat. And it’s important to remember that outperformance above an index is often generated in bursts and not consistently added every month.

In a universe as large and as complex as ‘international equities’, no-one has either the time or experience to realistically cover the entire spectrum of investment opportunities. To give you an idea, there are over 45,000 shares listed across 60 of the world’s main stock exchanges. If you’ve got $100,000 to invest globally Kerr Neilson and his team of 27 investment staff, from Platinum Asset Management will professionally manage a portfolio on your behalf for roughly $1,500 a year. Given their experience, the resources they have at their disposal and their track record, that’s a bargain and, looked at objectively, not something you can replicate yourself.

Luck is another important factor in overconfidence bias and one to be wary of when managing your own investments. Plenty of investors would have experienced great returns from a single stock and attribute the outcome to their skill rather than just getting lucky.

Overconfidence and hindsight biases are a natural human tendency, but when it leads you to sack perfectly competent managers and trade them for the next hottest thing, or take on the management of your portfolio yourself without having the skills or resources, it may undermine your long-term investment strategy and cost you dearly. Understand why you’ve appointed a manager and recognise your limitations in replicating what they do (particularly in the more complex asset classes). Revisit your investment thesis regularly and if it still stacks up (based on criteria other than the most recent outcome), stay the course.

Final words

Overconfidence and hindsight biases manifest themselves in all areas of life. But unlike believing you’re a better driver than you objectively are, they can be costly when it comes to investing and managing your finances.  Being mindful of them is key, as you’ll be surprised when they rear their heads. Most importantly, be objective and have a clear decision making framework to ensure they don’t undermine your long-term wealth creation strategy.

 

All Eviser content is covered by our Terms and Conditions

Disclosure: Eviser staff own units in Platinum International Fund.