Wednesday, May 1, 2013

Investor Overconfidence

Roughly a year ago, according to this MarketWatch article, Fidelity released a poll indicating that 91% of their "active investors" expect to equal or beat the returns of the stock market over the next year.

More specifically, 62% apparently expected to do better than the market and 29% expected to match market performance.

So only 9% expected to do worse.

Well, maybe Fidelity has an exceptional group of investors compared to the average but, more likely, this is just another example of investor overconfidence. Now, it's certainly possible quite a few might do just fine over a shorter time frame, but there is just overwhelming evidence that most investors do rather not at all well against the stock market over the longer haul. From this paper by Professor Terrance Odean and his colleague Professor Brad Barber:

"The majority of the empirical evidence indicates that individual investors, in aggregate, earn poor long-run returns and would be better off had they invested in a low-cost index fund. This evidence of poor performance is particularly compelling when we include transaction costs (e.g., commissions, bid-ask spreads, market impact, and transaction taxes). While transaction costs are an important component of the shortfall, a second component is the poor security selection ability of individual investors documented in many studies that we reviewed in the prior section. These observations lead one to wonder why investors trade so much and to their detriment."

This doesn't just apply to individual investors, of course.*

"Most people think they can find managers who can outperform, but most people are wrong. I will say that 85 percent to 90 percent of managers fail to match their benchmarks. Because managers have fees and incur transaction costs, you know that in the aggregate they are deleting value." - Jack Meyer, former President and CEO of the Harvard Management Company from 1990 to 2005, commenting on investment managers

"Of the 355 equity funds in 1970, fully 233 of those funds--almost two thirds--have gone out of business. Only 24 outpaced the market by more than one percentage point a year--one out of every 14. Let's face it: These are terrible odds!." - John Bogle in The Little Book of Common Sense Investing
(This quote, and others from the book, can be found here.)

"The statistical evidence proving that stock index funds outperform between 80% and 90% of actively managed equity funds is so overwhelming that it takes enormously expensive advertising campaigns to obscure the truth from investors." - From The Motley Fool

The Fidelity study is just another good example of how overconfidence impacts investor behavior and results. In a separate paper, also by Professor Odean and Professor Barber, adds this thought:

"Active investment strategies will underperform passive investment strategies. Overconfident investors will overestimate the value of their private information, causing them to trade too actively and, consequently, to earn below-average returns."

Fidelity's poll also indicated that roughly two-thirds claimed they had matched or outperformed over the past twelve months; 80% claimed they had done the same the year before.

The MarketWatch article rightly compares these results to surveys of driving ability that reveal people are often hopelessly optimistic about their own driving skills. Well, it's not much different for professionals. I've referenced this Charlie Munger quote before but it is relevant because:

" self appraisals of prospects and talents it is the norm, as Demosthenes predicted, for people to be ridiculously over-optimistic. For instance, a careful survey in Sweden showed that 90% of automobile drivers considered themselves above average. And people who are successfully selling something, as investment counselors do, make Swedish drivers sound like depressives. Virtually every investment expert's public assessment is that he is above average, no matter what is the evidence to the contrary." - Charlie Munger speaking to Foundation Financial Officers in 1998

He also later added...

"Smart, hard-working people aren't exempted from professional disasters from overconfidence. Often, they just go aground in the more difficult voyages they choose..." - Charlie Munger speaking to Foundation Financial Officers in 1998

Part of the problem is that some judge, inadvertently or not, that they've performed better than they have in reality; that an objective comparison of returns produced by all positions held in all accounts over time to an appropriate index would reveal lesser results. The article makes the point that "there is a difference between judgmental performance -- what you think you gained -- and actual performance," with the result being participants not necessarily measuring themselves objectively.


"...investors, when asked about performance, focused on winning trades to prove their ability to deliver strong returns in the future."

As an example, here's just one possible scenario among many. An investor may choose to ignore or at least underweigh the losers and underperformers in a portfolio when assessing their own performance. Let's say one part of a portfolio has recently tripled in value, while several earlier investments or trades went sour. Well, the actual return is naturally the combined results. Yet that investor might -- in what he or she thinks is a well-intentioned attempt to objectively gauge their performance -- decide to weigh more heavily a recent big win (or set of wins) while choosing to treat earlier losses as an anomaly; as just some reflection of past errors or maybe bad luck that's unlikely to be repeated.

Well, that might make for a pleasant rationalization, and it is certainly possible that lessons have been learned, but you can't just arbitrarily ignore certain results and still make a sound judgment.

My point is that, while some might expect otherwise, it's not always easy to be objective when measuring one's own performance.

"The first principle is that you must not fool yourself, and you are the easiest person to fool." - Richard Feynman

So, in a detached and unbiased manner, the entire investment portfolio over time needs to be measured against an appropriate index. Results shouldn't be partitioned into separate "mental accounts" or financial buckets (a speculative vs investment account, for example). This mistake wouldn't be difficult to avoid if behavioral biases didn't come into play.

Later in the same MarketWatch article, Professor Terrance Odean also added the following:

"You are talking about active, engaged people who wouldn't be spending time at the trading summit or webcast -- who wouldn't be trading 36 or more times a year -- if they didn't think they were above-average investors," he said. Even if they are not better than average, they pretty much have to believe they are just in order to do what they are doing, to be active investors."

It's worth mentioning that results over very short time frames don't reveal much. A year or two is just too short to gauge relative performance.

"Absent a lot of surprises, stocks are relatively predictable over twenty years. As to whether they're going to be higher or lower in two to three years, you might as well flip a coin to decide." - Peter Lynch

In addition, how much risk was taken needs to be considered even if risk happens to be far less easy to quantify than returns (and, of course, beta is not a meaningful measure of risk). That it is difficult to quantify makes it no less relevant. So risk-adjusted performance needs to be objectively measured over longer time frames.

The being objective part is just harder than some might assume.

It's also worth pointing out that there is plenty of evidence that many market participants do their buying and selling at just the wrong time.**

Unfortunately, too many investors buy when stocks are generally expensive (when the outlook is rosiest and the good times seem likely to continue, indefinitely). They also tend to sell under the opposite conditions. This happens in a remarkably reliable manner. Many stocks were being bought with high confidence in the late 1990s when expensive by any fundamental measure. In contrast, once many individual securities -- if not the market as a whole -- became rather cheap during the financial crisis (and after), interest in purchasing equities became quite low.

As always, it's about buying what you understand when cheap (at a discount to conservative value) and being realistic about limits and strengths.

Overconfidence destroys risk-adjusted returns in the long run.

Index funds certainly do make sense for many investors. Still, there are those who seem to take the wisdom of owning index funds to another extreme. They don't just suggest it is very difficult to do better than a market as a whole; they go further and seem to imply or assert outright it's effectively not possible to do so.

Well, those that think this way are conveniently ignoring things like what Buffett wrote in The Superinvestors of Graham-and-Doddsville and his own long-term track record. The list of investors with a long enough track record of outperformance may be a short one, but it's certainly not non-existent.

Buffett himself has expressed support for the wisdom of owning index funds as a way to gain exposure to equities.

"Most investors, both institutional and individual, will find that the best way to own common stocks (shares) is through an index fund that charges minimal fees. Those following this path are sure to beat the net results (after fees and expenses) of the great majority of investment professionals." - From the 1996 Berkshire Hathaway (BRKaShareholder Letter

For many long-term investors, low cost, not often traded, index funds can be a sensible approach. Yet, that reality doesn't logically lead to the conclusion no investors would be better off buying individual equities. It's knowing one's own limits and abilities.

"By periodically investing in an index fund..... the know-nothing investor can actually out-perform most investment professionals. Paradoxically, when 'dumb' money acknowledges its limitations, it ceases to be dumb.

On the other hand, if you are a know-something investor, able to understand business economics and to find five to ten sensibly-priced companies that possess important long-term competitive advantages, conventional diversification makes no sense for you." - From the 1993 Berkshire Hathaway Shareholder Letter

I've said before that it's not likely, over the long haul, for many investors to do better than low cost index funds. Yet there's a big difference between not possible and not likely.

Again, maybe Fidelity has an exceptional group of investors performance-wise compared to the average. Otherwise, it's arithmetically tough to see how that underperformance by the 9% could absorb the outperformance achieved by the 62%.


Long position in BRKb

Related posts:
Chasing "Rearview-Mirror Performance"
Index Fund Investing
Investors Are Often Their Own Worst Enemies, Part II
Investors Are Often Their Own Worst Enemies
The Illusion of Skill
Buffett's Bet Against Hedge Funds, Part II
Buffett's Bet Against Hedge Funds
The Illusion of Control
Charlie Munger on LTCM & Overconfidence
"Nothing But Costs"
When Genius Failed...Again

* John Bogle wrote the following back in 2007: "The percentage of managers outperformed by the broad market index is, well, time-dependent. On a given day, it's likely about 55%; over a year maybe 60-65%, over a decade perhaps 75-80%, and over 50 years...well, there's no data (yet!) on that!

But the probability statistics suggest that over a 50-year period, some 98% of managers will lose to the market index."

** According to Vanguard founder John Bogle, from 1984 to 2002 the average mutual fund delivered a 9.3% annual return compared to the S&P 500's return of 12.2% a year. Even worse, during that same period the average fund investor, according to DALBAR, earned just 2.6% a year.
(The average fund investor does much worse largely due to ill-timed buy/sell decisions and fund selection. In other words, a timing penalty and a selection penalty. Bogle adds why he thinks the DALBAR study might actually overstate the annual returns. See his explanation under the Is the DALBAR Study Accurate? section for more details.)
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