Practical Tips for Overcoming Overconfidence Bias

If you’re now convinced of the need for greater humility in your investment approach, a natural next question is, “Where do I start?” The journey toward admitting ignorance and culpability is winding and difficult but has both financial and relational rewards. Here are a few places to start:

Man of steel – You’ve likely heard of a “straw man” argument in which a weakened caricature of an opposing opinion is presented, only to be dismantled. A less discussed but more effective critical thinking technique is to create a “steel man”, which represents the very best thinking and most rigorous empirical proof of an opinion with which you disagree. Rather than using the straw man as a rhetorical punching bag to feed your ego, build a steel man that will sharpen your thinking, cause to you to look in dark corners and consider new vantages.

Love the questions – In Letters to a Young Poet, Rainer Maria Rilke writes to his protégé: “I want to beg you, as much as I can, dear sir, to be patient toward all that is unsolved in your heart and to try to love the questions themselves like locked rooms and like books that are written in a very foreign tongue. Do not now seek the answers, which cannot be given you because you would not be able to live them. And the point is, to live everything. Live the questions now. Perhaps you will then gradually, without noticing it, live along some distant day into the answer.” Western culture is in love with certainty and bravado but the uncertainty of markets necessitates that we pursue a dynamic approach that is rooted in a fascination with the process rather than looking for silver bullets. The paradoxical truth is that only by learning to love the questions will we ever find the answers.

Take Your Time – For years scientists have puzzled at the evolutionary reason for depression. Species tend not to adapt in ways that are self-harming and yet depression on its face does very little good and a whole lot of harm to the organisms it touches. But more recent research shows that deep sadness may have a strong evolutionary purpose that is rooted in the depressive tendency to ruminate on problems. By playing and replaying a negative event over and over in our minds, we often arrive at solutions that can be called upon at a future date. What hurts in the moment may be profoundly beneficial down the road. As Warren Buffett has pointed out, there are no called strikes in investing; all the time pressure we may feel is arbitrary and self-imposed. We would do well to follow the admonition of John Dewey in How We Think, - “To be genuinely thoughtful, we must be willing to sustain and protract that state of doubt which is the stimulus to thorough enquiry, so as not to accept an idea or make a positive assertion of a belief, until justifying reasons have been found.”

Take the outside view – When making a decision we tend to rely on what social scientists call the “inside view.” The inside view is our perception of a decision as informed by our own biases, anecdotal experience and a convenience sample of whatever data pops to mind first. Conversely, taking the “outside view” means a more dispassionate appraisal that depends more on base rates, probability and facts than convenience and personal experience. In Think Twice, Michael Mauboussin sets forth four steps to taking an outside view of a problem. They are:

1.     Select a reference class – compare your problem to other problems like it

2.     Assess the distribution of outcomes – examine rates of success and failure

3.     Estimate probabilities – based on the external evidence, estimate timelines, failure rates and obstacles to success

4.     Fine tune your prediction – let bumps in the road and changing circumstances alter your estimate accordingly

By relying on external data, you are likely to arrive at a much more realistic picture than by leaning on your personal experience. If it takes most people two years to complete a task, you are unlikely to finish yours in six months. The outside view is an effective way of combatting ego risk by reminding you that you’re not that great.

Those who can, teach – A quick question for you, gentle reader, “Do you know how a toilet works?” On a scale from 1 to 10, how familiar would you say you are with the workings of a toilet? Go ahead and answer. Now, explain to me in detail the mechanics of a toilet, I’ll wait. Done? Ok, now let me ask again – on a scale of 1 to 10, how well do you understand the workings of a toilet? Research by Steven Sloman of Brown and Philip Fernbach at the University of Colorado shows that having to teach a concept has a humbling effect that brings our beliefs more in line with our actual understanding. The pair have used this technique to moderate beliefs about everything from single payer healthcare to, well, toilets and have found that, “As a rule, strong feelings about issues do not emerge from deep understanding.” The next time you feel as though you must buy or sell a security, take a moment to explain, in detail, the factual reasons why this is so. You’re likely to find that your enthusiasm has gotten the best of your brain and nothing brings them back into sync like having to teach.

Wall Street: Where the Future is More Certain than the Present

Suppose I asked you what you would be doing in 5 minutes. Odds are, you would be able to answer that question with some high degree of certainty. After all, it will probably look a bit like what you are doing at the time you were asked. Now, let’s move the goalpost back a bit and imagine that I asked you what you would be doing five weeks from now. It would certainly be exponentially harder to pinpoint, but your calendar may give some clues as to how you will be engaged at that time. Now imagine you were asked to forecast your actions five months, five years or even fifty years from now – damn near impossible, right? Of course it is, because in our quotidian existence, the present is far more knowable than the distant future.

What complicates investing then, is that the exact reverse is true. We have no idea what will happen today, very little notion of what next week holds, a slight inkling as to potential one-year returns, but could take a pretty solid stab at thirty years from now. Consider the long-term performance of stocks by holding periods:

Range Of Returns on Stocks: 1926 to 1997

 Holding Period    Best Return    Worst Return

1 Year                     +53.9    %    -43.3    %
5 Years                   +23.9    %    -12.5    %
10 Years                  +20.1    %    - 0.9    %
15 Years                  +18.2    %    + 0.6    %
20 Years                 +16.9    %    + 3.1    %
25 Years                  +14.7    %    + 5.9    %

Over short periods of time, returns are nearly unknowable. Stocks are up about 60 percent of the time and down about 40 percent of the time, but the highs and lows are both very dramatic. Over a time period more reflective of a long-term investment horizon, however, the future becomes far more certain. Returns average just over 10 percent per year, with the worst case being around 6 percent and the best case being nearly 15 percent. Not so scary anymore, but it does require a fundamental rethinking of reality, something that seems not to be happening. As statistician extraordinaire Nate Silver says in The Signal and the Noise:

“In the 1950s, the average share of common stock in an American company was held for about six years before being traded – consistent with the idea that stocks are a long-term investment. By the 2000s, the velocity of trading had increased roughly twelvefold. Instead of being held for six years, the same share of stock was traded after just six months. The trend shows few signs of abating: stock market volumes have been doubling once every four or five years.”

Intuition tells us that “now” is more knowable than “tomorrow” but Wall Street Bizarro World (WSBW) says otherwise. As Mr. Silver points out, more access to data and the disintermediary effects of technology make our tendency toward short-termism even greater. But the growing impatience of the masses only serves to benefit the savvy investor. As Ben Carlson says in A Wealth of Common Sense, “Individuals have to understand that no matter what innovations we see in the financial industry, patience will always be the great equalizer in financial markets. There’s no way to arbitrage good behavior over a long time horizon. In fact, one of the biggest advantages individuals have over the pros is the ability to be patient.”

For much, much more on applying behavioral finance to the management of both self and wealth, please check out "The Laws of Wealth" by Nocturne Capital founder, Dr. Daniel Crosby.

A Taxonomy of Behavioral Risk

Psychologists and investment professionals have now identified over 100 separate biases, heuristics and cognitive quirks that cause us to make poor financial decisions. While this work is important, it is also unwieldy for the average investor who has a basic notion that behavior matters but is unable to track and protect against such a broad universe of potential error. Understanding that these 100+ errors are all undergird by a few common psychological tendencies, Nocturne Capital created this Behavioral Risk Taxonomy. The 5 general themes here encompass all of the individual errors but also provide a simple framework from which advisory and investment processes can be constructed that seek to overcome these tendencies. The ideas presented in the document linked below were instrumental in designing our investment process and we hope they are similarly instructive in your own efforts at compounding meaningful wealth. 

Behavioral Risk Taxonomy