God is a Capitalist

Thursday, October 13, 2016

How over confidence destroys earnings

“The curious task of economics,"  wrote Nobel Prize winner in economics Friedrich Hayek "is to demonstrate to men how little they really know about what they imagine they can design."

In other words, good economists are humble and that shows how few good economists live in the US.

Investors should be humble, too, and researchers have provided the proof. Two professors at the University of Maastrict published a paper at the beginning of this year on the question of “How Does Investor Confidence Lead to Trading?” The problem is not that initial successes spur investors to greater confidence.
Hence, we find evidence that our measure of investor confidence refers to a certain type of individual, as it is stable over time...Moreover, there is no evidence that any of the small fluctuations in investor confidence are driven by past returns, that is, that high returns lead investors to learn to be overconfident...That is, confident investors generally have lower returns (because of their higher turnover, see Section 5.1), but variation in those lower returns does not change their confidence.
In other words, the overly confident investor is always confident whether winning or losing. And men don’t have a monopoly on excessive confidence:
The regression also shows that females are more confident than males. This effect is in line with the role of confidence in our framework, that is, reliance on intuition. It is also consistent with the evidence on reliance on intuition and gender differences in Butler et al. (2013).
Most of the readers of this blog will be aware of a multitude of tools to assist them in trading, but the overly confident investor relies on just one:
...asked to indicate based on which method or information source (i.e., technical analysis, fundamental analysis, financial news, professional advice, family acquaintances, own intuition) they trade...more confident investors indicate to more often rely only on their intuition.
 For overly confident people, experience doesn’t help either:
...average confidence for the investors does not increase with competence. The average of confidence is 5.50 for the “novice” group, 5.31 for the “advanced” group, and 5.44 for the “very advanced” group...

Investors with above-average confidence suffer from a monthly turnover rate 8.6 percentage-points higher than investors with below-average confidence. As a result, “investors with above-average confidence underperform investors with below-average confidence by 88 basis points per month.”

Investors who rely on their intuition tend to buy at market tops and sell at market bottoms.

I spent 15 years in public relations and one of the major principles I learned was that attitude problems, such as overconfidence, can only be fixed by at least three years of intense counseling or a significant disaster in one’s life, such as a divorce. Since over confident investors don’t learn from their mistakes, as the authors wrote, they are likely to have a spouse leave them. The over confident investors appears to have a lot in common with obsessive gambles.

So if any readers know of over confident investors who are going through a crisis, point them toward Hayek, the most humble economists I have ever read except for Mises.

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