One of the coolest aspects of my summer working for Ritholtz Wealth Management was being able to ask smart people dumb questions One of those, which I directed to Michael Batnick, was: “Is there an emotional bias where winning seems more likely if you have recently been successful?” Two seconds after I hit send on Slack I felt a pit in my stomach as I realized what I had missed. What I was really asking about was confidence.
Confidence is the most dangerous emotion because it leads us to act, whereas its opposite (fear, anxiety, etc.) tend to freeze us into inaction. And as I hope to have gotten across on my previous posts, a decision to act is almost always a gamble on probabilities. Overconfidence can be deadly because it adds unknown and unproven variables to your decision making process, impairing your odds of success significantly.
Because I’ve frequently been the victim of overconfidence in my poker career I can share with you how I learned to conquer my bias. The first step is understanding that the world is divided into two realities. There is objective reality (in which 2+2=4, the Earth orbits the Sun, and Bill Belichik now and forever owns the Jets) and then there is the subjective reality that exists inside our heads. We must always strive to be fully conscious of both because when you let them merge into one you are no longer engaging with the world honestly.
Here’s how this has worked for me: Imagine yourself sitting at a poker table in a flashy casino surrounded by old men stinking of cigarettes and Amaretto. First hand you are dealt pocket aces. The guy next to you puts you all in preflop with his pocket kings. The dealer deals the flop and a third king shows up on the river. You and your pocket aces lose. In this instance there are immediately two reactions. The first in my head: “This game is rigged. First hand I sit down and this jabroni happens to get kings when I get aces and beats me. Surely this establishment is catering towards bad players and I won’t be able to win here.” But then I acknowledge reality as it actually is: “The mathematical odds of running pocket aces into pocket kings is around 5% in a full ring table and the odds of pocket kings beating pocket aces is around 20%. Man, I got super unlucky.”
While the results won’t be affected by which reality you perceive, your emotional reaction to the event surely will. According to my diligent research (Wikipedia) there are three distinct ways overconfidence manipulates us: (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. This explains why being aware of both realities is so crucial to success. In my head I overestimated my skill, undermined my opponent, and was positive the game was rigged. But when acknowledging actual reality I can eliminate those negative thought processes, which if allowed to fester would lead me to make further bad decisions.
My idea for this post came from a recent article from Josh Brown responding to this Wall Street Journal question:
As the U.S. stock market continues to set all-time highs, many investors are proudly adhering to their mantra of “buy and hold.” That is what financial advisers preach, and investors are sticking to it.
For now, anyway. The tougher question is this: Will they stick to buy and hold if the market tumbles?
Which reality are these investors living in? The optimist in me (my subjective reality) wants to believe that people have gotten smarter over the years and now understand the power of holding market indices. But the realist in me (objective reality) knows that is not the case.
I believe the average investor who has been moving their money to Vanguard over these past few years thought something like this. “I believe that my money should be beating the market. I believe that I’m onto something that other people aren’t aware of. I am making the awesome decision of investing through Vanguard because they will make me lots of money.” Now let us evaluate what the thought process should be like. “I am probably not among the top 1% of investors who can pick his own stocks and outperform the market. Vanguard’s models have outperformed the market for years and I believe that their process will continue to work over the long run.” While today the results of these thought processes are the same this will not be the case for when the bull market turns bear. Which investor do you think is more likely to stick with his strategy when they start to lose, the investor who lives in his own head or the investor cognisant of his reality.
Confidence is a tricky thing because it dictates so powerfully how we view the world. If we have too much of it bad things are prone to happen and if we have too little of it conversely nothing may happen.