Friday, December 5, 2014

Investors Overestimate Their Own Returns

So it turns out that market participants have a tendency to overestimate their own investment results.

I found this particular bias very surprising -- much more so than the many other common investing biases -- when I first came across it. I mean, how could it be that the overestimation of returns is a pervasive problem? Well, it apparently occurs quite a lot. Maybe others are less surprised by the tendency, but it's certainly far more prevalent than I would have expected.

Jason Zweig recently pointed out that "nearly 90% of investors exaggerated their returns and that many who thought they had beaten the market had been beaten by it."

This is based on some research that was done in the late 1990s.

More recent research offered a similar conclusion. It points out that investor experience does reduce "the simple mathematical error of estimating portfolio returns, but seems not to influence their behavioral mistakes pertaining to how good (in absolute sense or relative to other investors) they are."

So experience matters but in a rather limited way. In fact, it showed that investors overestimate their returns and not by a small amount. It turns out that investors actually overestimated their own returns by greater than 11 percent each year.*

Every study has its limits, of course, but this is at least an indication that many do far worse than they think.

What makes this behavior tough to alter? Well, a tendency to believe that overestimating investment results is a bias that others have is certainly a contributing factor.

Here's how one study explains what's known as bias blind spot:**

"...individuals see the existence and operation of cognitive and motivational biases much more in others than in themselves."

A separate study describes it this way:

"Bias turns out to be relatively easy to recognize in the behaviors of others, but often difficult to detect in one's own judgments."

It would seem like that what leads investors to overestimate their returns should be easy to avoid but, well, it's apparently just not.

Awareness alone will hardly combat the tendency but it's a start.

An objective measurement system for the complete portfolio against an appropriate benchmark with an emphasis on the long-term might be helpful but, as the study above points out, this isn't strictly a measurement problem. It's important that things are NOT compartmentalized into separate buckets. In other words, if money was lost on something speculative, for example, it counts. Whether highly speculative or not, it's a permanent capital loss. Some also might choose to recognize gains while ignoring certain losses. It all naturally counts.***

So why do investors tend to not judge their own performance objectively?

Well, some suggest that market participants -- especially those who are very active -- may act this way to make themselves feel better about their results and to justify all the effort. They choose to selectively remember the most lucrative moves they've made while ignoring those that were less so. Whatever the reasons, if better understood by participants it just might lead to changes in behavior and, ultimately, a more realistic assessment of results.

In this article, Professor Terrance Odean said that even when investors "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 not that temporary losses in the short run -- and sometimes even over the intermediate run -- are necessarily a problem. In fact, temporary losses are pretty much inevitable even for those who are very good at investing in equities. It's that, in order to measure results in a meaningful way, the poor performers -- especially those that are likely to become either permanent losses or produce subpar results over the long run -- can't be ignored.

Yet that's what some choose to do in order to make themselves feel better about their overall results.

Here's how Professor Meir Statman explained it later in the same article.

"The people who like to trade, who want to trade or who feel better when they are trading, they will look at their numbers in a way that justifies" continuing to trade.

Statman also said:

"They're going to justify it and they will sound logical -- at least to themselves..."

Feeling better and justifying doesn't change the fact that the results are subpar. Allowing oneself to be fooled in this way is a terrible way approach such a serious thing.

There are other ways of compartmentalizing, in order to feel better about results, even if it increasingly torches reality. For example, choosing to not include cash in the total return calculation. Well, all the investable cash counts whether it happens to be invested at any particular time or not. If a fund manager sits on some extra cash for whatever reason, whether it turns out to be wise or not, that directly impacts total return. It is counted -- and very much should be counted -- in the total return calculation. This is done whether being in more cash leads to a favorable outcome or not. The same thing applies for the rest of us if relative and absolute results are to be objectively measured.

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

So setting up an objective way to measure sounds easy enough but much of the above research more than suggests it's not.

I'd add that it's also important to not measure results over shorter time horizons. How someone has performed over one or three years -- and especially less than that -- should be of little interest. The problem here is that it might be a very long time before the results reveal it wasn't worth all the trouble.

In any case, if after a reasonable period of time an investor is underperforming -- especially if, as the research above seems to indicate, by a substantial amount  -- it's probably time to move on to more of an index fund approach.

Time will be better spent elsewhere.

The bottom line is that investors tend to overrate themselves.

Best to work hard at trying to not be one of them.

Adam

[An earlier version of this post was a draft that was mistakenly posted.]

* This has been covered to an extent in prior posts.
** A quick reference to this was made in my most recent post.
*** It's also naturally important that relative risk, though far more difficult to quantify than returns, is considered carefully.
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