The last thirty years have seen huge advancements in behavioural finance research. This field combines psychology with economics to help understand why investors make irrational investment decisions.
Understanding what causes poor investment decision making can help you steer clear of some common mistakes. It can also empower you to enhance your long-term investment performance and wealth. As the Chinese proverb goes “Your greatest enemy is yourself”. This month we look into overconfidence bias and how it can impact your investment decisions.
Overconfidence bias leads investors to have greater confidence in their judgments than their actual accuracy. This causes investors to trade too often due to an overoptimistic belief in their ability to pick stocks and time markets.
Just like the 93% of drivers who believe they have better than average skills, most investors think they are likely to beat the market return. This may explain why more than 80% of the investment dollars in Australia are still managed by ‘stock pickers’ (active funds) despite overwhelming evidence that these strategies underperform the market return after fees and costs.
In a 2006 study entitled “Behaving Badly”, researcher James Montier found that 74% of professional fund managers believed that they had delivered above-average performance. Of the remaining 26% surveyed, the majority viewed themselves as average. Few considered their performance below average despite 50% actually being in that group.
Related to overconfidence bias is the ‘hot hand fallacy’. This is the flawed belief that a person who has experienced success with a random event has a greater chance of further success in additional attempts. The term comes from basketball where commentators often describe players as being on a ‘streak’ with their shooting. In 1985, a psychologist and mathematician team disproved this theory that recent shooting success predicts success in subsequent shots. They found that each shot was completely independent – and that people have an inability to understand and accept randomness.
The ‘hot hand fallacy’ can tempt investors to increase their investment size in response to recent profits. It also leads investors to chase returns – buying into stocks, funds or assets that have performed well recently. Unfortunately this is not a smart strategy because the recent performance of a stock, fund or asset has no bearing on future performance. If anything, inflows chasing recent success often precede periods of significant underperformance. We wrote about the dangers of chasing returns in our February newsletter “Chasing returns can harm your financial health”.
The following chart shows asset classes ordered from best to worst performance between 1998 and 2012. As you can see, good performance one year has no bearing on the performance over future years. Investors that only invest in one area, like Australian shares or property, also tend to have portfolios that are more volatile. This is why we believe that most investors are best served by diversifying their portfolios across broad asset classes. A portfolio that diversifies across many markets is less vulnerable to the impact of swings in performance by any one market.
Over the past 20 years investors who have resisted the temptation to try and beat the market have been rewarded and seen their wealth increase substantially more than more than active investors. Over that time, a simple stock market index fund delivered an annual return of 12.8%. Over the same period the average active fund delivered a return of just 10.0%. Compounded over that period, each $1,000 invested in the index fund grew by $10,120 – the magic of compounding returns – while each $1,000 in the average active fund grew by just $5,730, just 57% of the market’s return – a victim of the tyranny of compounding costs.*
Looking longer term, if you invest $1,000 for 65 years at an 8% average return you will end up with $148,800. If you pay 2.5% per year in fees over that timeframe your end balances reduces to $32,500. That $116,300 difference represents what you will have paid to the financial services industry.
The two most important lessons you can learn from overconfidence bias are to avoid chasing returns and resist the temptation to try and beat the market.
Patience and passivity are powerful forces working in your favour to help you generate substantial long term wealth.
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* John Bogle, Don’t Count on it! Reflections on Investment Illusions, Capitalism, “Mutual” Funds, Indexing, Entrepreneurship, Idealism, and Heroes (2010)