As a fan of British tennis I’m having to pinch myself at the moment. For all my life we’ve been a laughing stock; a Brit reaching the second round at Wimbledon has been a cause for national celebration. But now we’re the Davis Cup champions and, after more heroics from Andy Murray against Japan at the weekend, we’ve made it through to this year’s quarter-finals.
We have though been conditioned over the years not to get too carried away, especially as Serbia and Novak Djokovic lie in wait in the next round.
Overconfidence is part of the human psyche. It serves us well in so many ways. But it’s very destructive in other areas of our lives — investing being a perfect example.
Think about it. Most of us tend to think we’re better than the average driver, better than average at getting on with people or, as Jack Bogle once told me with a twinkle in his eye, better than average lovers.
By definition, only half of us can be better than average at anything. The logical conclusion, then, is that a high proportion of those who consider themselves “above average” are in fact below it — and blissfully unaware of their incompetence.
It always amazes me how confident people are about trading on the stock market. They read a book, or a few articles in the money pages, and they suddenly think they have an edge. Financial markets reflect the opinions of millions of traders around the world; they incorporate new information into prices within milliseconds. It’s completely bonkers for an amateur investor to assume they have some vital knowledge or insight that no one else possesses.
To quote William Bernstein, “trading stocks is like playing tennis against an invisible opponent; what the investor doesn’t realise is that he’s volleying with the Williams sisters”.
There have been several studies that show how prone investors are to overconfidence. For example, a study called Positive Illusions and Forecasting Errors in Mutual Fund Investment Decisions found that they tend to inflate both their future and past performance. More than a third who believed that they had beaten the market had actually underperformed by at least 5%.
A more recent study by Kent Daniel and David Hirshleifer identified a very strong link between overconfidence on the one hand and excessive trading and lower returns on the other.
OK, you might say, I personally don’t have the skill to pick stocks, or to choose when to buy and sell, but I think I can find someone who does. Again, let’s look at that rationally.
The asset management industry has ballooned in size over the last 30 years. Charley Ellis estimates there are now around 200,000 active fund managers in the world. The problem is not that there’s a lack of skill, but rather there’s too much of it. With so many professional investors competing for a finite amount of alpha, it should be no surprise that only a tiny fraction of them are able to outperform consistently after costs.
The scale of the task fund managers face is brilliantly explained by Larry Swedroe in his book, The Incredible Shrinking Alpha, in which he uses, appropriately, another tennis analogy.
At the height of his powers, says Swedroe, Roger Federer was the greatest tennis player of his era. That was despite Andy Roddick having a better serve, Andy Murray a better backhand, Rafael Nadal a better baseline game and so on.
Yet while Federer’s opponents were other tennis players, fund managers aren’t just up against the Murrays and Nadals of the stockpicking world; no, they’re attempting to outwit a far more formidable opponent, namely the collective wisdom of the entire market.
It’s as if, Swedroe says, each time Federer stepped on the court he faced an opponent with Roddick’s serve, Murray’s backhand and Nadal’s skill at the baseline. If that had been the case he may never have won a single tournament.
The bottom line is that however good we think we are at tennis or anything else, we can’t all be better than average. Investors need to beware of overconfidence, to be realistic about their level of competence, as well as their ability to identify competence in professional money managers.
Adopt the outlook of a British tennis fan and you can’t go far wrong.