What You Don't Know about Investing
It ain’t what you don’t know that gets you into trouble. It’s what you know for sure that just ain’t so.
I recently got around to watching The Big Short. I thought the movie was so good that I immediately downloaded the book to my Kindle. For anyone who hasn’t seen the movie or read the book I would certainly put both at the top of your summer list. The Mark Twain quote above was on the screen at the beginning of the movie.
The Big Short chronicles the events leading up to the bursting of the Housing Bubble and the Great Recession. The story shares the details of how several groups of really smart people profited to the tune of millions of dollars by independently daring to question the conventional wisdom that housing and real estate prices always rise and that everybody pays their mortgage.
The lesson I want to point out is not how smart these people were – and they certainly were smart and highly motivated. What I want to point out is how the rest of the world seemed to ‘know’ that a collapse in housing prices was impossible and that even if it did happen it certainly would not infect the rest of the economy. The party line out of Washington, D.C. during and after the fact seemed to be that the event was entirely unpredictable – although the cast of characters in the story proved otherwise.
There is a term for the condition that afflicted the world during the events leading up to the now infamous ‘Lehman Moment’. That term is overconfidence bias. Overconfidence bias occurs when individuals think of themselves as better at making investment decisions than they actually are. Overconfidence bias has the potential for disastrous consequences in all aspects of life including making investment decisions.1 During my twenty-five year career in the investment business, I have actually seen overconfidence bias financially ruin lives. But the main reason that these real life financial disasters tend to regularly occur is generally not because investors make bad investments. The main culprit for these undesirable outcomes in my opinion, is that adequate risk control measures are not employed. The investors in question simply insist that they ‘know’ what the future holds. This often leads them to see no reason to protect themselves. (I’ve also seen fortunes made because people didn’t understand the risk they were taking and got lucky.) Whether you are optimistic (bullish) or pessimistic (bearish) you don’t ‘know’ what the future holds – not with the stock market, not with your company stock and not with the real estate market. If you think you do have the ability to predict the future then you suffer from overconfidence bias and it’s probably affecting your investment returns. Remember, it’s what you think you know for sure that just ain’t so that gets you into trouble. By the way, 93% of American drivers rate themselves as better than the median.2
1 Wikipedia.org –Plous, Scott (1993). The Psychology of Judgement and Decision Making.
2 Wikipedia.org – Svenson, Ola (1981) “Are we all less risky and more skillful that our fellow drovers?” Acta Psychologica.