Who is Overconfident?

I was struck by a recent article on "overconfidence" and how it hampers investment returns.  It is persuasive and suggests several different interesting themes.

A Brief Digression

Before turning to this theme, I would like to hit a few highlights.

Thanks to Zack Miller, who kindly included me on his Super Bowl team of investment bloggers.  It is a clever idea and he has some great choices.

Readers who have access to Merrill Lynch research should check out today's research summary.  Their team was opining on the Fed, just as I did yesterday.  Ethan S. Harris takes on a number of myths about the Fed, mostly emanating from the perma-bear community.  The gist is that the Fed is not on the point of a "sharp knife" choice.  It is more of a balance beam with a three-year time horizon.  Harris does a nice job of examining the Fed balance sheet, demonstrating two key points:

  1. The existing size of the balance sheet is not inflationary, since Fed lending is filling a gap in the normal lending process; and
  2. The reduction of the balance sheet may take may years to complete, without an inflationary effect.

I am surprised that the Merrill Lynch team does not get more visibility in mainstream media and on financial blogs.  They are important and have excellent credentials.

Overconfidence Leads to Losses

Advisor Perspectives is a great source geared to the interests of people like me — financial advisors concerned about the individual investor.  Yesterday's update featured a nice piece of academic research from Terrance Odean at Berkely.  His study shows a group of frequent traders who have "excessive confidence" in their methods and seriously lag in their returns.  One might quarrel with the definition of excess overconfidence (men), but the general concept is quite interesting.

Who is Excessively Overconfident?

This is really a trap question.  Many people are confident.  Who is overconfident?  Who is excessively overconfident?  It is really, I believe,  a clever way to ask about sentiment.

I am hearing a lot about investment guru's who have had a "hot hand."  This includes people who have been wrong for decades.  I am amazed that traders are so easily seduced by a short period of apparent success.  How about the Super Bowl system that was 12-1 lifetime?  The theory was that the experienced team beat the newbies.  That one was a loser last Sunday.  I also hear from many traders who "got it right" in 2008 and now see the same thing.  They are so confident….with so few comparative cases.

The lesson is that most investors do not know how to detect data mining.  They focus on the wrong Taleb book.

They are aware of Black Swans and yet willing to be Fooled by Randomness.

Meanwhile, most have not read either book!

I am not sure what others are seeing, but the report from my investors and potential new clients is completely one-sided.

Investors are Fearful.

Everyone is fully steeped in the worries of the market and the predictions that we are setting up for another 2008.  Here are my own sentiment indicators:

  • The gang at TheStreet.com's Real Money site continues to be bearish;
  • The Minyanville  crew has the same slant;
  • The most popular investment bloggers are the bearish "pop economist" guys;
  • The "most followed" people on Seeking Alpha are relentlessly bearish; and
  • My client calls are all about worry.  No one grasps the idea of getting in when others are fearful.

It is always difficult to gauge sentiment, but perhaps the old sentiment methods do not work in the Internet age.  The marginal invested dollar is quite different now from what it was even ten years ago.

Investment Conclusion

My own posture is officially bearish for the three-week time horizon, but I have also highlighted the need for investors to make decisions reflecting their own time frames.  This is one of those times.  There are many attractive stock choices.

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  • Brett Alexander February 12, 2010  

    I have no idea what they are trying to accomplish at Minyanville.

  • TraderRick February 14, 2010  

    You bring up a fascinating area of trader behavior that has always puzzled me. I’ve read in multiple sources that one attribute of successful traders is the ability to be sufficient confident in their trade theses to execute on those trades, but yet at the same time, they must be malleable enough to recognize when they are wrong. If highly-successful traders are right only 53% of the time, isn’t it irrational to be “highly confident” if you’re only right roughly half of the time?
    I expect the takeaway is that confidence is mostly a chemical state of mind, rather than an epistemological state of being “right” or “wrong” about the unknowable future. Confident people aren’t necessarily more right than un-confident people; they just believe in themselves more, which has other positive benefits.
    Would love to hear others’ thoughts about this seeming contradiction.

  • Brian February 14, 2010  

    Minyanville saved me a fortune in 2008.
    So whatever they’re trying to accomplish, they should keep it up.

  • Frank Sayegh February 15, 2010  

    The GDP figures for Q4 2009 as well as corporate earnings have been ignored in favour of an impending- disaster scenario that will lead to the collapse of the world economy. Hogwash ! Go with the evidence and be careful and forget the bull****.