Ever since Icarus flew too close to the Sun, Ulysses mocked the Cyclops, and the Hare ridiculed the Tortoise, individuals have struggled with overconfidence. We've always seen ourselves as rational creatures--Descartes believed that rationality is the only reliable tool for attaining knowledge--but the sobering reality is that reason is riddled by desire and emotion, ancient heuristics and systematic biases. Our frontal lobes are a highly evolved but deeply flawed piece of tissue.
In finance this sin is all the more vital. Our ingrained resistance to say "I don't know" is linked to the demise of Long-Term Capital Management (which included two Nobel-Prize Laureates on its payroll), the Great Recession, and the dot-com bubble. Just about every story of financial collapse is a textbook case of overconfidence.
Given that overconfidence is so tightly coupled with financial collapse, I've always been deeply curious about how to avoid it. Must we make a Socratic pledge to admit our ignorance? Are there specific strategies that we can adopt?
The answer is a little bit of both. In Your Money & Your Brain, financial writer Jason Zweig writes that one virtue of smart investing is awareness--"How much you know is less important than how clearly you understand where the borders of your ignorance begin"--but he also outlines a few specific tips. Six are curated below:
1) "I Don't Know, and I Don't Care"
To succeed as an investor, you don't have to outsmart Wall Street at its own guessing game. You don't need to know what eBay's earnings will be to the nearest penny, whether energy and gold stocks will keep going up, what next month's unemployment report will say, or which way interest rates or inflation are headed. A total stock market index fund (TSM) is a basket that holds a piece of virtually every stock worth owning, at rock-bottom cost. If you buy and hold two TSM funds--one for U.S. and one for international stocks--then you no longer need to have an opinion about which stocks or industries or sectors will do well or poorly. This way, you can win the prediction game by simply refusing to play it.
2) Create a "Too Hard" Pile
[Warren] Buffett himself believes that the key to his success has been knowing what he doesn't know. "We have a ton of doubt on all kinds of things," says Buffett, "and we just forget about those." Buffett adds, "The essential principle is what [Buffett's business partner] Charlie [Munger] calls the 'too hard' pile, where we put things we don't know how to evaluate. We get to that pile with about 99% of the ideas that come our way."
3) Measure Twice, Cut Once
Behavioral finance writer Gary Belsky and psychologist Thomas Gilovich suggest using an automatic "overconfidence discount" of 25%. Apply it to both the high and low end of the range, making the upside smaller and the downside bigger. If, for instance, you think a stock is worth between $40 and $60, then crop each number by 25%, yielding a new range of value between $30 and $45.
4) Write it Down, Right Away
Psychologist Baruch Fischhoff who has studied overconfidence for more than thirty years, suggests using an investing diary. "Keep a record of what was on your mind when you made predictions," he says, "and try to make those predictions as explicit as possible."
It's important to document your reasons for investing before you buy. Memory researcher Elizabeth Loftus has shown that your recall of how you felt earlier can be easily "contaminated" by what happens later...
Tuck your diary entries away for a year. Then go back and see how accurate your predictions were, whether you tended to underestimate or overestimate, and how good your theories were. You're not looking to see whether or not your investments went up; you already know that. Instead, you're looking to see whether they went up for the reasons you expected.
5) Learn What Works by Tracking What Doesn't
To get a reliable picture of your stock-picking ability, you need to measure it over a long time and many choices. You also need to look at the roads not taken. Psychologist Robin Hogarth of Pompeu Fabra University in Barcelona suggests that you monitor the performance of three groups of stocks: those you own, those you have already sold, and those you thought about buying but ultimately didn't. Monitor all three baskets with an online portfolio tracker.
6) Pretend You're Four Years Old
As every parent knows, four-year-olds have a habit of asking "Why?" over and over again until they've exhausted Mom or Dad's store of knowledge. Asking "Why?" four or five times is a good way to test the limits of your own (or someone else's) knowledge. If a financial planner says you should put a pile of money into a mutual fund specializing in Chinese stocks because "China is the place to be," ask "Why?" If he answers, "Because it's going to be the world's fastest growing economy," ask "Why?" again. If he replies, "Because China will continue to have low manufacturing costs," ask "Why?" again. Chances are, you'll never get to a fifth "Why?" People who don't really know what they're talking about can rarely answer "Why?" more than twice.