In his book Behavioral Finance and Wealth Management, CFA and CFP Michael M. Pompian begins his examination of 23 different behavioral biases with an analysis of the “overconfidence bias” stating: “Overconfidence is one of the most detrimental biases that an investor can exhibit. This is because underestimating downside risk, trading too frequently and/or trading in pursuit of the 'next hot stock,' and holding an under-diversified portfolio all pose serious ‘hazards to your wealth.'” Pompian describes this bias as, “unwarranted faith in one’s intuitive reasoning, judgments, and cognitive abilities”(59). This bias has far-reaching implications and has been studied by researchers in many fields including those in the field of behavioral finance. One of the most common ways of explaining the bias is to note the results of a simple question: do you consider yourself better than, equal to, or worse than the average driver? Not surprisingly, most people will answer “better than,” despite the fact that, by the mathematical definition of what “average” is (and assuming a normal distribution), most people are in fact just that – average drivers. The problem surfaces when people tend to believe that they are above average at most things including investing. Consider the Alibaba IPO. On its first day of trading that was open to the public, it closed at $93.89 a share. It took another 33 days for it to close at a price above that level, but on the first day, more than 271 million shares were traded by people convinced that they were going to make a quick buck. The truth of the matter is that the real money was made by the people who got a hold of those shares the day before at $68.
The point is not that IPOs are a bad investment. Many can be a great investment when approached with the right perspective and a significant amount of due diligence. The point is that our belief that we are better than average can cause us to wade into dangerous waters. I once heard a speaker say that by the time something shows up in the news for the masses to consume, the trade is already over. IPOs are usually the best play for people closest to them. By the time they reach the masses, the big money has already been made.
How do you recognize a tendency towards overconfidence, and, furthermore, how do you correct it? Pompian suggests asking yourself questions such as, “How much control do you believe you have in picking investments that will outperform the market?” or “How would you characterize your personal level of investment sophistication?” (57). Another suggestion would be to diligently read up on people who are market movers and ask yourself how you stack up against them because they are, more often than not, the person on the other side of the trade. When considering a potential investment it’s always good practice to pose the question – what does the other person stand to benefit from this transaction and how does that affect what I stand to gain? Or, similarly, if this investment is so great why are they offering it to me and not keeping it for themselves? Remember, the odds are that as a retail investor you’re probably average. So be careful trying to cut corners, and, when necessary, seek professional advice from someone you deem to be above averge.
Pompian, M. (2006). “Behavioral Finance and Wealth Management.” Wiley Finance: Hoboken.
*A version of this article first appeared on this site on April 17, 2015