Depressed Investors Don’t Need Feedback. Everyone Else Does.
Courtesy of Tim at The Psy-Fi Blog
Although it’s easy enough to show that overconfidence is a blight on investment performance we need to be careful that we don’t blind ourselves to an important reality. Overconfidence is not simply a problem for investing, it’s an issue that applies to most of us, most of the time in most of the things that we do. It’s not something we can simply stop because we wish it so.
In fact, it turns out that there is only one group of people who are not habitually overconfident. Unfortunately these people are, instead, habitually miserable. It turns out that to invest sensibly you need to be depressed.
Overconfident or Depressed
That most people are overconfident is a finding that’s been replicated scores of times on a wide variety of tasks. However, the research showing the so-called depressive realism effect indicating that depressives are almost alone in not exhibiting overconfidence at least suggests a reason – that feeling confident about ourselves is a necessary antidote to real life and that if we saw our lives and the world we live in as the ghastly messes they truly are, we’d be unable to function properly.
Trading off our mental health and general happiness in order to improve our investing returns, however, seems a bit of a bad bargain – although, we could equally well argue that if most people properly analysed their real returns they’d probably feel pretty depressed anyway. Of course, it’s quite possible that when an overconfident investor runs into the brick wall of a real bear market the cognitive car crash this causes can lead them to develop an aversion for all types of investing activities. Anything rather than face the grim reality of life as an average stock picker.
Feedback’s the Key
Fortunately there is an alternative to taking the anti-happy pills but it does require investors to force themselves to face their decisions, something the evidence suggests that many investors are reluctant to do. The problem is that unless we analyse what we’ve actually done we won’t change our behaviour, even when it’s obviously not in our interests, until we have no choice. Which will usually be when the repo merchant knocks on the door. Alternatively we need to calibrate ourselves against our actual performance and learn to adjust what we do.
Calibration’s a pretty simple affair, nothing more than the process of receiving and using feedback. The trouble with stockmarket investing is that there’s no simple, instantaneous feedback process to allow us to calibrate ourselves – often it takes months or years before we know whether any given decision was a good one or not. However, the evidence across many areas suggests that when people force themselves into calibrating their performance their success rate improves – often dramatically.
Geology, Accountancy and Weather Forecasting
Schoemaker and Russo’s 1992 paper on Managing Overconfidence is essential reading for investors. They give three examples of groups who don’t exhibit overconfidence – geologists, weather forecasters and accountants. In all three cases these groups receive rapid and effective feedback by design. In their own words:
"Being well calibrated is a teachable, learnable skill"
The beauty of this accelerated feedback is that it attacks overconfidence without needing to address the underlying psychological biases that cause it. And, of course, it’s something every investor can do if they’re motivated to do so.
Don’t Rely on Memory
In adding accelerated feedback to the armoury it’s crucially important not to rely on memory nor to tie ourselves down to definite statements. No investment is ever a 100% certainty and neither is any memory. Memories are too often simply reconstructions of what we want to believe. Investing decisions must be written down and then analysed at various points. This needs to cover both the positive and negative decisions – a decision not to invest is as important as a decision to invest, both can – with hindsight – turn out to be mistakes. The critical thing is to analyse the decisions in the light of the information used at the time and that generated by hindsight.
Yet it’s impossible to get every decision right so coming up with a probability judgement is important. Retrospectively analysing decisions where we thought there was a very high probability of success yet which have failed tells us something important about our inner states. Indeed conducting this analysis can be eye-opening: companies can suffer poor performance for any number of reasons many of which would have been completely unpredictable at the time. You may have covered every possible foreseeable risk and still be left with losses when the Finance Director runs off with the CEO’s spouse. And your shock would be nothing to that of their wives’.
The Harder You Practice …
Despite this, a fair percentage of investing results will turn out – with hindsight – to have been perfectly predictable. Calibrating your decisions is the start of the process of turning hindsight into foresight. At a qualitative level a simple list of pros and cons with regard to any given investment is an important start. It’s really important to force yourself to face the possible negatives of any decision at the time you make it. It’s even more important to look back at these judgements in the light of experience to decide whether or not you were being realistic in your judgements.
Shining the hard light of reality on our decisions doesn’t come naturally. We’re in danger of violating our own overconfident preconceptions about ourselves. Who wants to come face to face with the reality that we’re not very good at something we pride ourselves on? Yet the numerical evidence suggests that this is exactly the situation pertaining to a large proportion of investors.
… The Better You Get
The alternative is to continue to stumble blindly around in the hope that everything will turn out to be OK. If people insist on becoming active investors rather than passively letting the markets take their course, then they need to concentrate on improving their abilities. Experts get to be expert by practicing, not by simply wishing it to be so. Of course, if you accept the arguments of the more extreme proponents of efficient market theories then you’d conclude that this is a waste of time. However, that argument was roundly demolished many years ago some geezer called Warren Buffett in The Superinvestors of Graham and Doddsville which demonstrated that certain pre-selected investors were able to outperform the markets over many, many years.
Of course, it’s unlikely that simply by more carefully analysing your investment decisions that you’ll end up joining the exalted ranks of the super investors. However, if you’re going to invest actively it would be highly irrational to not try. Alternatively, of course, you could just try and make yourself really depressed before making any investment decisions.
Related articles: Overconfidence and Over Optimism, Pascal’s Wager – For Richer, For Poorer, O Investor, Why Art Thou Rational?
