The costliest bias of all
Posted by Robin Powell on May 10, 2018
Human beings are not cut out to be good investors. We just aren’t. We’re hard wired to do the wrong things at the wrong times. The secret is to be aware of our behavioural biases and, as best we can, to try to manage them — ideally with the help of an objective third party like a financial adviser.
Search for “behavioural biases” on Google and you’ll find them there are hundreds of them. But, from an investing point of view, which is the most damaging? Which one is most detrimental to our long-term investment returns? In my personal opinion, the costliest bias of all is optimism bias and, closely connected to it, overconfidence.
Of course, as with all behavioural biases, we have them for a reason, and optimism is no exception. People with a positive outlook on life and the future tend to be healthier, both physically and mentally, than those who don’t. Optimism bias helps us cope with life, its frustrations and disappointments. (Trust me, you couldn’t support Aston Villa without it.)
But investing is a classic example of an area in which a tendency towards too much optimism can land us in trouble.
I recently interviewed Lisa Bortolotti, a Professor of Philosophy at the University of Birmingham, and an expert on this subject, for the first in series of videos about behavioural finance, called Your Own Worst Enemy.
Academics, she explained to me, have identified three main ways in which excessive optimism can militate against us when it comes to investing:
- the illusion of control, the sense that we have control over something when we don’t;
- the better-than-average effect, or assuming that we’re better at something than we actually are; and
- unrealistic optimism, or the tendency to underestimate the chances of a negative outcome.
In this video, we look at each of those three factors in turn.
Remember two things in particular while watching it. First, just because you think you aren’t prone to optimism bias yourself, that doesn’t mean you aren’t. It’s one of the characteristics of overly optimistic and overconfident people that they don’t recognise themselves as such.
Secondly, even if you yourself aren’t susceptible to undue optimism and overconfidence, you shouldn’t assume that others you may be paying to help you invest sensibly are immune to it — your financial adviser, for example, or your fund manager.
Optimism bias could be costing you dearly, and the chances are you don’t even know it.
In his book, The Intelligent Investor, first published in 1949, the famous investor Benjamin Graham wrote this: “The investor’s chief problem — and even his worst enemy — is likely to be himself.”
In this series of videos, we’ll be looking at some of the behavioural biases that hold investors back.
And we’re going to start with one of the most prevalent biases of all — optimism bias, and specifically overconfidence.
Lisa Bortolotti, Professor of Philosophy at the University of Birmingham, says: “Optimism and overconfidence are not exactly the same phenomenon, but they are closely related. So, it has been found that people are vulnerable to three types of optimistic biases. One has to do with the illusion of control: so, people tend to think that they have some control over events that are independent of them.”
Yes, we know that, historically, equities have delivered returns of around 5% over inflation over the long term. But the fact is that investors have no control over the financial markets whatsoever.
James Norton from Vanguard Asset Management says: “What you don’t know is what individual stocks are going to go up tomorrow or which funds are going to outperform over the next week or month or year. Those are really driven by news.”
The second problem regarding optimism is what’s called superiority bias.
Lisa Bortolotti says: “The superiority bias, which is also called the better-than-average effect, is the idea that we tend to think of ourselves as better than average in a number of domains. So, we may think that we are more attractive, smarter, more generous as well.”
Victor Haghani from Elm Partners says: “There’s just a feeling that we as humans have of exceptionalism, that we all kind of think that we’re a little bit above average at whatever we do. So the idea that hope springs eternal among people in whatever it is that we’re doing I think also applies to investing.”
The last of the three factors Lisa Bortolotti referred to us is called unrealistic optimism — or underestimating the likelihood of a negative outcome.
Lisa Bortolotti says: “Because what we might think is that our past performance or our knowledge of a certain field makes us more able to predict what kind of event will happen. And I think, in the financial world, it’s possible that we may think that we will be able to know whether a certain company will be successful or whether certain rates will go up or down. And this capacity, that we think we have to predict how things will go, will make us make decisions that are more bold and do not take into account maybe other factors that we should factor in.”
James Norton says: “You have an investor, whether it’s a private investor or a professional, and you make some good investing decisions. Now, as a result, that could lead them to believe that they’ve got a high level of skill. The fact is, they may have a high level of skill or they may have been lucky. The consequences though are that, as a result of that, they may start taking additional risk.”
Of course, optimism and confidence are largely positive traits to have. They’re good for our health and mental well-being for a start. But they can be counter-productive in some areas of life, and investing is definitely one of them.
Your Own Worst Enemy is a six-part video series. It’s been commissioned by RockWealth LLP and it’s produced by Regis Media, the company behind The Evidence-Based Investor. We’ll be releasing five more videos over the next nine months, followed by a longer documentary in early 2019. If you’re a financial adviser, and your firm would like to collaborate with us on similar educational video content, we’d love to hear from you.