The overconfidence effect is a well-established bias in which a person’s subjective confidence in his or her judgments is reliably greater than the objective accuracy of those judgments, especially when confidence is relatively high. Overconfidence is one example of a miscalibration of subjective probabilities. Throughout the research literature, overconfidence has been defined in three distinct ways: (1) overestimation of one’s actual performance; (2) overplacement of one’s performance relative to others; and (3) overprecision in expressing unwarranted certainty in the accuracy of one’s beliefs. The most common way in which overconfidence has been studied is by asking people how confident they are of specific beliefs they hold or answers they provide. The data show that confidence systematically exceeds accuracy, implying people are more sure that they are correct than they deserve to be. – Wikipedia
September saw markets give up some of the gains we’ve seen in the very strong run since March 2020. The realities of COVID/lockdown related supply-chain issues, quickening inflation and political uncertainty around the globe seem to be finding some acknowledgement in financial markets. There is a heightened sense of apprehension. Most investors we speak to have two questions: 1) What’s next? 2) How should we position ourselves?
COVID and the resultant lockdowns have had a knock-on effect on global supply chains. This has led to shortages in a number of key areas. Shortages lead to price increases. The US inflation rate is currently north of 5%, a level breached only once previously in the last 30 years (mid-2008). The Fed tells us this uptick in inflation is transitory, but inflation is notoriously difficult to predict. Inflation has implications for interest rates, and interest rates for asset prices. There’s also the question of what impact trillions of dollars of stimulus will have on inflation and asset prices, not to mention a host of other issues which further compound the uncertainty of the future.
And that’s really the answer to the question of “What’s next?”: Uncertainty. The future is and always has been uncertain. We don’t know what inflation will do next, nor do we know exactly how financial markets will react. And that’s just concerning inflation. There are many other important factors that we also know very little about.
Contrast this basic truth with what you see daily in the financial media. There is no shortage of pundits brimming with confidence ready to tell you precisely what the future holds. Ironically, you’ll find someone to confidently express whatever you want to hear. Their accuracy is nowhere near their confidence. Of course, the media houses will parade the ‘winners’ who got their calls right in the last round for as long as their credibility lasts. There are always people predicting everything, so it’s easy find someone who got it right after-the-fact. Consistently doing the same ex-ante is a different story.
The reality is that no-one seems to be able to consistently predict the future. And even when we do make correct predictions, markets often don’t react the way we’d have anticipated. This makes prediction-based investing problematic, and prone to error.
“How should we position ourselves?”
When we’re asked the questions “What’s next?” and “How should we position ourselves?” the implicit assumption is that the answer to the second question depends on the answer to the first. But unless you’re able to answer the first question with a high degree of accuracy (vs. confidence), it should have very little influence on the answer to the second question.
Because we don’t know what the future holds, nor how markets will respond to specific events, we need to aim for a robust portfolio that is likely to deliver good results under a wide range of future scenarios, and stick to it. Discipline is by far the most underrated trait of successful investors. In an industry where everyone is ‘clever’, and as a consequence overconfident, discipline is the key to avoiding costly mistakes and achieving consistent results.
The problem is that there tends to be a very large gap between our perceived accuracy (i.e. confidence) and our actual accuracy. This is overconfidence. We need to think soberly about our ability to predict the future.
One of the biggest mistakes that investors make is to reposition their investment portfolios in a major way in anticipation of some future event of which they are confident they know the outcome. Time and time again investors will sell out their portfolios or go all-in on a specific asset/industry/geography, abandoning a sound investment plan and setting in motion a series of behavioural biases that make it very difficult to get back to where they should be. It takes just one big mistake like this to derail a successful investment journey. Now we can always get back on the right track, but it can be difficult, and these mistakes can be costly.
Let’s say you sold everything in 2016 as RBS suggested, predicting an impending global deflationary crisis. By the end of the year, global stock markets had risen 18%. What now? Do I buy everything back again? If so, on what basis? By this time there’s a good chance you’ve set an anchor around the level you sold. “If the market just gets back to where I sold, then I’ll buy everything back.” So we give it some more time… In 2017 markets climbed another 24%.
This chain of events leads either to a kind of financial depression where you never get back to your target portfolio, or capitulation where you take your medicine and move on. The longer you wait, the more difficult it becomes to swallow the medicine. Granted, you might get lucky, but those stories are the exception rather than the rule. It’s better not to put yourself into this kind of position.
So what does a robust portfolio look like?
A robust portfolio first has the correct asset allocation. This means having enough cash to meet short-term liabilities, and enough risk assets to meet your long-term liabilities. Next, a robust portfolio is focused on high quality assets with reasonable valuations. The portfolio must also be diversified in terms of industries and countries, but not to the extent that quality or valuations are compromised. Finally, a robust portfolio avoids excessive leverage, which triggers liquidation during a crisis.
Any major changes in your overall investment portfolio should aim to draw you closer to your ideal portfolio, not away from it. Once this portfolio is established, do not allow “What’s next?” questions to draw you significantly away from it. If you are going to entertain these questions, keep the changes small. Better yet, if you spend less time thinking about these questions, you’re less likely to make these kinds of mistakes.
Finally, it’s worth remembering that against a backdrop of perpetual uncertainty which included the Great Depression, WWII, numerous recessions, wars, market crashes, inflation in the ‘70s, the tech bubble, the housing bubble, etc., the last century has seen the S&P 500 index grow from 4.4 to 4400, not counting dividends.