Hubris
Behavioral New World: Hubris(1)
September 1, 2020 Hubris. Sounds like something that might have washed up on the beach. “Lots of detritus and hubris on the beach after the storm last night.” Well, no. Hubris refers to an excess of pride or arrogance, a great word to describe overconfidence and to toss around at cocktail parties. And exuberant confidence surely is a key factor in success in investing not to mention life, wouldn’t you think? Consider the subtitle of the book The Confidence Factor by Judith Briles: Cosmic Gooses Lay Golden Eggs.(2) All of us would like to have a few (or more) golden eggs after all.
Well, a golden (nest) egg would be great, but a focus on confidence may not be the right path to amassing your personal financial empire. Why? Because it is so easy to become overconfident. And overconfidence is dysfunctional, leading to distortions, inaccuracies, and costly mistakes. Consistent with this idea, research shows that the more confident is a political forecaster, the less accurate his forecasts.(3) In addition to bad forecasting, there are other downsides to an excess of confidence. Let’s consider some examples.
In the realm of personal finance, overconfidence can lead to at least two errors that detract from investing success. The first of these is the tendency to underestimate risk, possibly because the overconfident investor feels that he can “get out in time” to avoid the risk if she needs to. Alternatively, an overconfident investor might believe that his perception of low risk is right, while believing that other investors incorrectly perceive high risk. Obviously, underestimating risk is not beneficial to your investment performance—if you do not grasp the risk you are taking, you set yourself up for greater-than-expected losses in your investments.
A second consequence of overconfidence in personal finance is the tendency to trade too often. Overconfident investors believe they see over- and undervalued stocks and trade frequently in an effort to exploit apparent mispricing. But this is illusory—in general investors cannot reliably identify mispriced stocks (that’s a topic for another newsletter). And although excess trading might seem to be benign, it is not—every trade has transactions costs (e.g., commissions, bid-ask spreads, and potential tax consequences). The costs of frequent trading can substantially degrade investment performance.
The erosional effects of frequent trading can be seen in the differential investment performance of men versus women. It turns out, perhaps not surprisingly, that on average men are more overconfident than women. When researchers examined the individual trading accounts of investors, they found: 1) men traded much more frequently than women; and 2) as a result, men’s investment performance was worse than women’s.(4) In another recently completed study, researchers concluded that margin traders—those who borrow to invest, thus taking on more risk—often are recklessly overconfident, and at times rack up unnecessarily large losses. Their performance compared unfavorably with plain vanilla investors who don’t try to juice up their returns with higher risk-taking.(5)
In the rarified world of the executive suite, research shows that overconfidence plays a destructive role in decision-making on the part of Chief Executive Officers. Perhaps you don’t find this conclusion surprising but are curious about how we know which CEOs are overconfident. Some researchers use the number of magazine articles about the CEO as a proxy, with the notion that a significant amount of press coverage–—and all the PR and attention it generates—leads to more overconfidence. Other researchers use an appearance on the cover of a prominent financial magazine—or several such publications—as a strong indicator of overconfidence. This is akin to the Biblical notion that pride cometh before (self) destruction.
Other research has examined the choice of language in CEO communications, or CEO tone of voice in conference calls, to infer overconfidence. Using these proxies, studies show that overconfident CEOs make a wide variety of decisions that serve their companies and their shareholders poorly, especially when their company acquires another company and they pay too much for the privilege.(6)
Whether personal investor or CEO or both, what can you do about overconfidence? A good place to start is to admit that overconfidence may be affecting your thinking and behavior, especially if you are male. You can challenge your beliefs, consider alternative explanations and scenarios, and ask others for a different perspective. For the latter, a trusted and informed friend, one who will tell you truths you may not want to hear, often can be very helpful. By the way, such friends become even more valuable – and rare – the higher you rise in an organization, or the wealthier you become.
Taking a slightly different tack, a popular columnist suggests, “Once you recognize the futility of …. seeing into the future, your tendency toward overconfidence will diminish.”(7) This view may be too extreme—some features of the future are fairly predictable—but there is clearly value in asking, “What if my predictions are wrong? What is an alternative explanation for what is happening? What if things unfold quite differently than I expect?” In being open minded and intellectually humble, you reduce the risk that your investment portfolio and your career will be washed up on the beach.
Notes:
Parts of this newsletter draw upon Chapter 6 of my book The Foolish Corner.
Mile High Press, 2008.
Expert Political Judgment: How Good is it? How Can we Know? Princeton University Press, 2005.
Women are, on average, more risk averse than men, consistent with them being less overconfident and thus less likely to underestimate risk. See Barber and Odean, The Quarterly Journal of Economics, Volume 116, Issue 1, February 2001, pp. 261–292.
“Leveraging Overconfidence,” a working paper by Barber, Huong, Ko, and Odean, 2020. Available at: https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3445660
See, for example, “The Hubris Hypothesis of Corporate Takeovers” by Richard Roll. The Journal of Business, Vol. 59, No. 2, Part 1 (April 1986), pp. 197-216, The University of Chicago Press.
Robert Frick, “The Illusion of Control,” Kiplinger’s Personal Finance, December 2011, p. 22.