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STANDUP Advice: The Tyranny of Overconfidence

John J. De Goey, CFP
0 Comments|August 10, 2007

Only 50% of the people can be above average.
Only 50% of the people can be above average.

You've probably read stories about the research showing that a large majority of the population thinks they're above average drivers. By definition, only half of any population can be above average at anything. Overconfidence is an affliction that many of us suffer from- and one that we would all do well to consider when investing our money. Virtually everyone would be well advised to be a little more humble when it comes to stock picking- but stock pickers are typically anything but humble.

In my 14 years of working in the financial services industry, I have yet to meet a money manager who will admit to being below average. Confessing to one's humanity is bad for business when engaging in security selection. In fact, money managers all profess to be brilliant. Every stock picker on the planet, it seems, thinks he's smarter than his average peer. That stretches the limits of credulity to me.

Let's think about this for a moment. In any given stock trade, there's a buyer and a seller. Both may be highly intelligent, diligent and insightful. Both must believe that they are capitalizing on a significant mispricing by doing the transaction. But only one of them can ever be right. The price is either too high or too low; it can never be both simultaneously. More often than not, the price is going to be more or less correct, so the buyer and the seller might have both encountered bid/ ask spreads as well as incurring transaction costs and tax liabilities that could have been avoided had they just hung on to the things they had in the first place. To add insult to injury, research shows that the security that was purchased underperforms the security that was sold in the following twelve-month period more often than not.

Nobel Laureate William F. Sharpe's paper "The Arithmetic of Active Management" explains this neatly. Another Laureate, Paul Samuelson, says this: "Ten thousand money managers all look equally good or bad. Each expects to do 3% better than the mob. Each has put together a convincing story. After the fact, hardly 10 out of 10,000 perform in a way that convinces an experienced student of inductive evidence that a long-term edge over indexing is likely."

There are many who share my concern that the money management industry is not so much about dispassionate, evidence-based advice, but rather the presumptive justification of product sales that maximize market share and EBITDA. If only advisors would take the approach that Scientific Testing And Necessary Disclosure Underpin Professionalism (i.e. if only advisors would STANDUP), consumers would likely have a very different perspective regarding the products they purchase and the strategies they employ.

I think it's wonderful that so many people have such supreme confidence in their own abilities. Unfortunately, all reliable evidence (that's right, there's not a single reputable study to the contrary) suggests that most people who try to "beat the market" fail as a direct result of having made the attempt and that the handful that are successful cannot be reliably identified in advance (i.e. their success is likely attributable to random chance as much as anything else).

This doesn't mean people shouldn't continue to try to beat the market. It simply means investors ought to be apprised of the odds going in. Most people recognize instinctively that they are unlikely to have a satisfying outcome (i.e. win more than they paid to play) when they buy a lottery ticket, yet many of these same people fail to recognize that they are encountering a similar experience (i.e. making less in active strategies than could have been made using passive ones) when they invest. My guess is that if people knew that the odds were actually against them going in, they'd be far less willing to make the attempt in the first place.

John J. De Goey, CFP is a Senior Financial Advisor with Burgeonvest Securities Limited (BSL) and author of The Professional Financial Advisor II. The views expressed are not necessarily shared by BSL.

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