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5 Tips for Overcoming Overconfidence Bias

One of the strange paradoxes of human psychology is that our tendency to be overconfident has both helpful and harmful aspects. After all, starting a restaurant or a small business both have low odds of success, but we are awfully glad that overconfident dreamers do it anyway! But while overconfidence may help us get out of the bed in the morning or encourage us to embark on an entrepreneurial journey, its impact on investment decisions is unfailingly negative. Today on the podcast, tune in to hear five concrete ways to beat overconfidence en route to having a more fulfilling life.

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The Dangers of Overconfidence (Part Two) - Special People are Cheaters

THE MYTH OF SELF-ESTEEM

Beginning with the 1969 publication of The Psychology of Self-Esteem, wherein Nathaniel Branden posited that self-esteem was the single most important facet” of personal well being, the self-esteem movement has been one of far-reaching influence. In the 70’s and 80’s anything seen as detrimental to self-esteem was done away with. Gold stars proliferated while red pens gathered dust. First place trophies gave way to awards for participation. In this new milieu, everyone was a winner; everyone was special. 

As this well-intentioned movement garnered support, scholarly research followed. In the thirty-year run up to the 21st century, over 15,000 articles were written on the impact of self-esteem on, well, pretty much everything imaginable. However, the results of these myriad studies were often confusing or inconclusive. In an attempt to make sense of the general trajectory of the literature on self-esteem, the Association for Psychological Science asked Dr. Roy Baumeister, an admitted proponent of the theory, to meta-analyze the extant data on the subject. What followed was what Dr. Baumeister would go on to refer to as “the biggest disappointment of my career.” 

Of the 15,000 studies taken into consideration, a paltry .013 percent of them (n = 200) met the more rigorous standards for inclusion into the meta-analysis. To begin with, it became apparent that many of the theories about self-esteem that had impacted policy were simply junk science. What’s more, the studies that did pass muster didn’t have much good to say about the construct’s predictive power. Self-esteem did not predict academic or career achievement, nor did it predict drug usage or violent aggression. The biggest finding to emerge from the self-esteem movement was that praise did not predict self-esteem, accomplishment did. Telling someone that they are special is insufficient if they have not worked to earn it. We have an accurate internal sense of when we have earned praise and when we have not. If we feel as though we are being patted on the back undeservingly, it does not move the self-esteem needle one inch.

THE ETHICS OF GIFTEDNESS

One of the thoughts behind the self-esteem movement was, that if you imbued people with a positive vision of themselves, they would be less likely to engage in anti-social behavior. Once again, the reality of specialness deviates quickly from the aspirational theory that underlies it. In fact, research shows that those who think of themselves as gifted, will often do anything to protect that label – even if it is unethical.

One of the most direct studies of this phenomenon involves students who were asked to fill out a “do it yourself” report card that would ostensibly be mailed to students at another school. The children involved were told that those on the receiving end of these report cards would be strangers – they would never meet them nor would they exchange names. By setting up the experiment thusly, the researchers were able to promote a scenario that would allow the children to lie with impunity, if they so chose.

Before filling out the DIY report cards, the kids were either praised for their effort or for being naturally intelligent. While very few of those praised for effort dissimulated on the grades self-assessment, 40% of those lauded for their specialness lied in their self-reports of academic achievement. Again, the shroud of specialness created a pleasant illusion that the students wanted to perpetuate at all costs. Whereas being complimented for being hard working has a wholesomeness that is it’s own reward, specialness is something that is won or lost in the outcomes. The impact of dishonesty is bad enough, but what if this dynamic played out on a grander stage and with infinitely higher stakes?

“A LITTLE JEWISH GUY FROM BROOKLYN”

By now we are all familiar with the story of Bernie Madoff, the financier who brokered the largest Ponzi Scheme in US history. In the case of Madoff, our familiarity with the story may actually be a disservice to an appropriate understanding of his motives. After all, in the minds of “have nots”, wealth is its own reward. Who wouldn’t want a private jet? Who wouldn’t want a $200,000 watch? We assume a very simplistic motive on Madoff’s part – greed. But the reality may not be that simple.

While the timeline for Madoff’s transition from legitimate businessman to crook is unclear, it appears as though he began his career on the up and up. In fact, Madoff’s firm legitimately pioneered the use of computer information to disseminate stock quotes. This technology was so groundbreaking, that after some initial testing it become what we now know as NASDAQ. Despite all of his success, Madoff felt unnoticed and unextraordinary saying, “I was upset at the whole idea of not being in the (Wall Street insiders) club. I was this little Jewish guy from Brooklyn.” For someone who had done so much and went on to cause such trouble, Madoff sounds weak and vulnerable in his account of his early career.

Much like a professional athlete who turns to “juicing” to rise to the top, Madoff began to apply his financial acumen in a more sinister manner, officially defrauding his investors (which included Holocaust survivor charities) of over $18 billion. But as he has said in interviews, it really was never about the money. Said Madoff, “We made a very nice living. I didn’t need the investment-advisory business. I took it on and got myself involved in it, but if you think I woke up one morning and said, ‘Well, listen, I need to be able to buy a boat and a plane, and this is what I’m going to do,’ that’s wrong.” Madoff’s subtext? It was never about the money, it was about respect.

Before long, Madoff’s too good to be true returns did result in the recognition he craved. “The chairman of Banco Santander came down to see me, the chairman of Credit Suisse came down, the chairman of UBS came down; I had all of these major banks” he says, “It is a head trip. (Those people) sitting there, telling you, ‘You can do this.’ It feeds your ego. All of a sudden, these banks which wouldn’t give you the time of day, they’re willing to give you a billion dollars.” Now Madoff was special, but as we have seen, with recognition comes the tenuous task of maintaining the label. Madoff was now a prisoner of his own need to be recognized. He said of living this lie, “It was a nightmare for me. I wish they caught me six years ago. Eight years ago.” Even in the face of this torment, he was unable to free himself from his need to be thought of highly by his peers, the Wall Street insiders who had never really accepted the Jewish kid from Brooklyn as one of their own. 

I don't imagine that anyone reading this is prone to or capable of the sort of sinister machinations of Bernie Madoff, but you are very wont to look for shortcuts to financial freedom. I recently sat down with a friend who was considering an "investment" that offered "15% annualized returns with protection of principal." I told her that I smelled trouble from a mile away and that it violated very basic principles of risk and reward. Looking at the pseudo-prospectus more closely, my fears only deepened. This was a scam. I warned my friend as loudly and emphatically as I could, but she ignored my warnings and proceeded with her original plan. I wish her the best but fear that she is in for some abrupt realizations about the laws of financial physics. Overconfidence may not make you a cheater in the same way Bernie Madoff was, but it may make you want to cheat the system in small ways: over leverage, excessive borrowing, a failure to diversify. Get rich quick and get poor quick are sides of the same coin; you're not so special that this rule doesn't apply to you too. 

Want more great content on the intersection of mind and markets? Check out The Laws of Wealth by Nocturne Capital founder Dr. Daniel Crosby - HERE

The Dangers of Overconfidence (Part One) - Special People are Quitters

Dmitri Martin, one of my favorite comedians, is known for his humorous sketches, delivered deadpan, that speak to harsh truths with which we are all well acquainted. One such sketch is the one where he compares most peoples’ concept of the path to success with the actuality of the path to success.

Most of us know intellectually that hard work and failure often precede success. We probably even have a couple of go to anecdotes (that do little to make us feel better about our own shortcomings, incidentally) – Michael Jordan was cut from his high school basketball team, Thomas Edison failed thousands of times before inventing a commercially viable light bulb filament. But, however much we may wish it were different, success is typically preceded by a good deal of imperfection and those who go on to do great things are the ones who learn to fight through.

So, what does a feeling of personal specialness have to do with stick-to-it-ive-ness? A great deal as it turns out. Carol Dweck and her team have pioneered the research in this field in the trenches of the New York City school system. Dweck’s team took a random sample of children out of their fifth grade classes, and in the first round of the experiment, provided them with puzzles simple enough that most children could excel. To the first group of children, she complimented their intelligence, “You did well, you must be very smart.” To the second group, she complimented their effort, “You did well, you must have worked very hard.”

For the second round of the test, the children were given an option. They could choose a harder test or a test equivalently hard to the first. Of those praised for hard work, 90% opted for the harder option, whereas a majority of those praised for intelligence opted to stay with the easier test.

It seems that people who believe that they are naturally gifted tend to quit earlier and choose simpler tasks than those who have been socialized to work hard. Feeling special produces a euphoric high that people are understandably hesitant to part with. Thus, when special people are confronted with an especially difficult task, they often back down, seeing it as a threat to their “crown of giftedness.” After all, why risk the possibility of failure when you could bask in the safety of “specialness?”

Many a doting parent has sought to buoy the self-esteem of their little darling by telling their son or daughter that they are smart. After all, it stands to reason that intelligent people are more successful and in the case of girls, it circumvents the sexist habit of focusing solely on attractiveness. But thirty years of research tells us that focusing on effort rather than specialness is the best way to encourage young Einsteins.

Dr. Dweck relates the story of “Jonathan” (a composite character) in her seminal article, The Secret To Raising Smart Kids.

“A brilliant student, Jonathan sailed through grade school. He completed his assignments easily and routinely earned As. Jonathan puzzled over why some of his classmates struggled, and his parents told him he had a special gift. In the seventh grade, however, Jonathan suddenly lost interest in school, refusing to do homework or study for tests. As a consequence, his grades plummeted. His parents tried to boost their son’s confidence by assuring him that he was very smart. But their attempts failed to motivate Jonathan. Schoolwork, their son maintained, was boring and pointless.”

What many a well-meaning parent has done when emphasizing innate gifts is create the perception that achievement is based on leveraging specialness rather than hard work. When children view themselves as special or gifted, they become accustomed and entitled to having work come easily to them. When it does not, they write it off as “stupid” or “boring.” Worse still, they believe themselves to be ineffectual in doing differently, since after all, their past ability to excel has all been predicated on natural gifts they did nothing to earn.

This mindset is doubly damning. When a child is successful, they are unable to truly take credit for their success, since it is a natural consequence of their unearned gift. When they are unsuccessful, they have no culpability and could not have done any better, since success is contingent upon a talent with which they were not blessed. This “either ‘ya got it or ‘ya don’t” attitude leads to something that psychologists call “learned helplessness.”

LEARNED HELPLESSNESS

The original research on learned helplessness was conducted by one of the fathers of positive psychology, Martin Seligman. Dr. Seligman’s experiment tested two groups of dogs. The first set of dogs were harnessed in and given a mild electrical shock which could end by pressing a lever inside of their cage. Soon enough, the dogs stumbled onto the correct response and learned to act in every instance of discomfort. The second set of dogs were similarly harnessed and shocked, but were initially unable to bring about the cessation of shock by pressing the lever. After repeated pairings with this helpless situation, they were then placed in new cages where their action could bring about the end of the shock by pressing the lever. Sadly, by this time, the dogs had conditioned themselves to helplessness and directed their energy toward enduring the pain rather than improving their plight.

It is easy to draw parallels between the helplessness of the dogs and a student who has bought into the notion that success is predicated entirely on innate specialness. After all, his success and failure is seen as being entirely out of his hands – so why try? Given the unintended consequences of praising children as special, Dweck and other experts on giftedness encourage taking a different tact. Rather than praising giftedness, they recommend praising hard work and encouraging a growth mentality. In so doing, children learn that they will be praised for process rather than outcomes. This approach empowers young minds and teaches them success is in fact a byproduct of effort and that whatever their natural gifts may (or may not) be, they can bring about improved outcomes with sweat equity.

The parallels between the examples given above and investors may not be immediately obvious, so let me take a run at describing why I think that overconfidence is one of the most harmful behavioral traits an investor can exhibit. Equity investing is, by its nature, an act that requires humility, patience and a willingness to be self-critical, none of which are hallmarks of overconfident people. Investors with an "I'm special" mentality, enter the capital markets and expect immediate success, which Mr. Market may be stingy to produce. When the overconfident investor doesn't achieve his desired result, he may quit altogether (dangerous) or double down in an effort to attain the return that he is "due" (doubly dangerous). Just as a child labelled gifted may quit too easily when school becomes tough, an overconfident investor may pout if they do not live up to their own internal hype as a Junior Warren Buffett. With both the child and the investor, the fix is the same - focus on process. You aren't special, but your discipline can be. The market may not be in your control, but your reaction to it is. In the long-term, achieving satisfactory returns in the stock market is less about being gifted and more about being process-driven. The bad news? You're not that great. The good news? Realizing how average you are is the first step toward doing something extraordinary. 

Want more great content on the intersection of mind and markets? Check out The Laws of Wealth by Nocturne Capital founder Dr. Daniel Crosby - HERE