Paying the price of overconfidence

(Published in the South China Morning Post on 7 January 2007)

Poor decision-making is largely to blame for the dreadful returns realised by US mutual fund investors. That is the conclusion of the Dalbar study, a yearly analysis of fund flows and fund performance first published in 1994.

From 1984 to 2002, US equity mutual fund investors earned an average annual return of 2.6 per cent compared with 12.2 per cent for the S&P 500 Index.

Dalbar estimated that 2.9 percentage points of the difference were due to fund underperformance and operating costs while a staggering 6.7 percentage points were due to poor decision-making by investors, specifically poor timing and fund selection.

In fact, John Bogle, who founded Vanguard Group and the first index fund, testified to the US Congress in 2003 that the returns were even worse on a dollar-weighted basis. Accounting for the huge sums that investors poured into "hot" technology funds in 1999 and 2000 at the top of the market, Mr Bogle estimated that returns were significantly in the red over the period.

Behavioural finance experts explain this poor decision-making in terms of our natural tendency towards overconfidence and bias. Researchers say people consistently overrate their knowledge and skill.

In their paper in the Sloan Management Review in 1992, Edward Russo and Paul Schoemaker presented the results of their tests in which securities analysts and fund managers were posed a series of questions and, in addition to being asked for a precise answer, were also asked for a range in which they were 90 per cent sure the actual answer resided. On average, the analysts chose ranges wide enough to accommodate the correct answer only 64 per cent of the time. Fund managers were even less successful at 50 per cent. Groups that very accurately calibrated their confidence levels included weather forecasters, bookmakers and professional bridge players.

So how does this overconfidence among fund investors manifest itself when it comes to. decisions to buy and sell mutual funds? Overconfidence impedes performance because investors consider outcome ranges that are too narrow. For example, if markets have fallen, investors significantly underestimate the likelihood of them bouncing. And the belief that a "hot" fund will continue to be so often becomes dogmatic.

Paradoxically, overconfidence prevents you from being aware of your overconfidence. I hear myself saying, "No! You are wrong! I am certainly not overconfident," in response to being so accused. We need to be shown the evidence.

Here goes. In a room of 30 people, what is the probability that two people share the same birthday? One in 100? One in 200? It can't be more than 10 per cent, can it? Well, it's actually 71 per cent. Surprised?

An example of erroneous perception is provided by "the Monty Hall problem", named for the host of US TV's Let's Make A Deal: you are on a game show where the objective is to win a car. The host shows you three doors and says there is a car behind one of them and a goat behind each of the other two. He asks you to pick a door. You pick a door but it is not opened. Then the host, who knows what is behind each door, opens one of the two you didn't pick to reveal a goat. He then offers you the chance to change your pick to the other unopened door. What should you do?

The problem was sent to Parade magazine's Ask Marilyn column in 1990. Author Marilyn vos Savant answered that you should always switch doors as this doubled your chances of winning from one in three to two in three. There was an avalanche of letters to the magazine, some from writers with a PhD in mathematics, saying she was wrong, and accusing her of lowering education standards. (Incidentally, Mrs vos Savant held the Guinness world record for the world's highest IQ from 1986 until 1989, when the ranking was abolished.)

You may think, as I did at first, that Mrs vos Savant is wrong and that switching doors wouldn't alter the odds. Surely, if there are two doors left, the chances are 50-50 either way, right? Wrong. I spent an entire evening trying to persuade one of my smarter friends that by switching doors you increase your odds. Not only did he disagree, but he was convinced he was right. I resorted to tearing up three pieces of paper, marking one with a cross, and repeatedly playing the game until he saw empirically the switching strategy did in fact double the chances of winning.

Once you are able to recognize the overconfidence that causes errors in your perception, you will be in a better position to make more sensible investment decisions.

The problem is that overconfidence otherwise helps us in our daily battle for survival. But while the need to appear competent and confident might help, for example, in securing a job promotion, it hinders sound decision-making in stock market investing.

Whatever your assessment of your own confidence, you would do well to remember that few people think they are below-average drivers. Fewer still think they are below-average lovers. To the real Schumachers and Casanovas out there, I salute you, as I suspect you can get by without really needing to be any good at investing.

For the rest of you, I suggest you keep asking yourself why your answer could be wrong and why other answers could be right.