The limits of confidence
August 04, 2020

The limits of confidence

Dr. Henning Stein. Global Head of Thought Leadership

The road to ruin

According to a wealth of research carried out over several decades, most of us consider ourselves above-average drivers. In one survey1, conducted in the US, 93% of respondents rated themselves as such.

It does not require a statistical genius to work out that this cannot possibly reflect reality. A few minutes spent trying to survive rush hour should be more than sufficient to disprove the theory. Unless there exists a very small and well-travelled band of extraordinarily bad drivers who bring mayhem wherever they go, the notion that the overwhelming majority of motorists are uncommonly safe and skilful is utterly risible.

What we have instead, of course, is a case of mass overconfidence. As many experiments have shown, humans harbour an unhealthy tendency to place undue faith in their own abilities – and it is not a phenomenon confined to the quotidian chaos of the highways and byways.

It is also rife, for example, in the world of investment. One celebrated study2 questioned 300 fund managers and found that 74% regarded themselves as above average at their job, with the rest – the notably modest ones, presumably – deeming themselves merely average. Here, too, perceptions clearly defy actuality.

Granted, a professional investor who freely admits to being below average should probably start searching for another career. Yet the fact remains that overconfidence in the markets, irrespective of whether an investor is professional or otherwise, can be as dangerous as overconfidence on the roads – especially now that “easy wins” look set to become less numerous.

The curse of the golden age

Overconfidence – also known in the literature of social psychology as illusory superiority – is among the most prolific cognitive biases. It seems fair to suggest that it is widespread, even though there is mounting evidence that cultural dynamics3 might significantly influence its occurrence.

There are many causes, but for investors there are perhaps two in particular that merit attention. The first is formative experience, and the second is the broader environment. Not least in recent years, these might be seen as inextricably linked.

By way of illustration, imagine that a fledgling, self-guided investor – let us call him Icarus, in deference to Greek mythology’s icon of hubris – decides to enter the markets in early 2009, in the wake of the global financial crisis. With what will become the longest bull run ever getting under way, the chances are that he enjoys a number of early successes.

Fast-forward to late 2019, by which time the S&P 500 has gained 468%4 in a decade, and Icarus could be forgiven for thinking himself an investment virtuoso. Yes, there have been occasional setbacks, but his portfolio has invariably recovered from adversity – often quickly. How could he not feel assured of his own brilliance?

The problem is that Icarus has become accustomed to a golden age of investing. He has revelled in an era largely defined by rapid population expansion, increased labour productivity, conspicuous global economic growth and – most pertinently of all – unusually attractive returns. Needless to say, the golden age is now over; and today, if he maintains his overconfidence when scouring the gathering clouds for silver linings, Icarus will almost certainly fly too close to the sun.

Compounding calamity

One of the greatest perils that overconfident investors invite stems from a refusal to concede that a loss-cutting retreat is sometimes the only sensible course of action. In short: they will not admit when they are wrong. As in any setting, those that cannot accept their errors are frequently doomed to pile blunder upon blunder.

Some of history’s most renowned figures have suffered this fate. Napoleon’s calamitous determination to press ahead with his invasion of Russia5 in the face of persistent setbacks offers a famous example: having become dangerously accustomed to victory, le petit caporal simply could not countenance the possibility of defeat.

Even Daniel Kahneman, the Nobel laureate whose pioneering psychological studies6 transformed our understanding of decision-making, was not immune. In the 1970s, when he was invited to help formulate a new curriculum for Israel’s high schools, he found himself caught up in a classic instance of collective overconfidence.

A veteran of similar initiatives warned that he had never known a scheme to take less than seven years and that around 40% of those he had been involved in had eventually come to nothing. Unmoved, most members of the team – Kahneman included – estimated that the project would be completed within 18 to 30 months. The plan fell to pieces eight years later, and the curriculum was never used.

As I wrote last year, everyone makes mistakes. Failure is an essential engine of progress – one to which we all contribute on a daily basis. Those who deem themselves spectacularly unerring neither have an incentive to improve nor will improve: like that 93% of “above average” drivers, they merely plough on until they at last ­discover the painful truth.

Confidence and crisis

So is there a cure for overconfidence? It is not as easily remedied as underconfidence, which traditionally stems from setting the bar for success unnecessarily high, but there is hope.

First and foremost, humility can be a powerful medicine. Viewing mistakes as key components of an endless learning process – as opposed to intolerable aberrations of which we are innately incapable – is vital for developing a proper sense of perspective and for reducing the likelihood of past errors being repeated.

After all, arrogance and intelligence are very seldom natural bedfellows, as Bertrand Russell recognised when he remarked: “Those who feel certainty are stupid, and those with any imagination and understanding are filled with doubt.” Thomas Sowell put it even more succinctly: “It takes considerable knowledge just to realise the extent of your own ignorance.”

Second, accountability is imperative. Across the board, from the most hobbyist investor to the most illustrious fund manager, comparative performance is the supreme arbiter. In the final reckoning, the only investors who can genuinely claim to be above average are those whose long-term track records are, indeed, precisely that: the others are either resolute fantasists or lamentably unwilling to evaluate their own accomplishments – such as they might be – against anyone else’s.

Given time, overconfidence is almost always exposed in the end. The difference today, amid the enduring swirl of an unprecedented crisis, is that exposure is liable to come much more swiftly than previously. By all means, we should stay confident during this challenging period; but overconfidence has arguably never been more misplaced or potentially damaging. Ultimately, like an inflated belief in one’s own prowess behind the wheel, it is little more than an accident waiting to happen.

Footnotes

Important information

  • The opinions referenced above are those of the author as of 27 July 2020.

    Where individuals or the business have expressed opinions, they are based on current market conditions, they may differ from those of other investment professionals and are subject to change without notice.