Three words that are rarely heard in the investment business and at the same time the most important to long-term success.
Because the future is unknown and having the humility to admit that is very hard for us to do. We’re wired instead with overconfidence – we tend to overestimate our abilities when it comes to sports, driving, investing and many other areas of life (Dunning-Kruger effect).
While a little bit of confidence can be a good thing in many areas of life, overconfidence, particularly in the investment world, can be disastrous. With overconfidence comes the tendency to overtrade and make highly speculative, concentrated bets on the future.
Many studies have shown that these attributes tend to lead to lower overall returns. The more confident you are, the more you trade, and the worse your returns are on average…
And interestingly, as men tend to be more overconfident than women, they tend to trade more (45% according to one study) and have lower risk-adjusted returns (1.4% less on average). The old saying “boys will be boys” seems to apply to investing as well.
What’s the best way for investors to manage their overconfidence bias?
1) Diversification: not putting all of your eggs in one basket.
2) Resisting the urge to trade (first, do no harm).
3) And sticking with a broad-based asset allocation plan.
Boring, I know; not nearly as exciting as letting it ride in the latest speculative fad. I completely agree, but successful investing is not supposed to be exciting or entertaining. By diversifying, you’re removing your ego from the equation and accepting the fact that you’re not likely to pick the next Apple/Amazon or make the next Big Short.
To the contrary, you are saying three important words when it comes to making precise predictions about the future: I Don’t Know.
Let’s practice this concept in response to some standard questions you hear on financial TV every day:
-Where will the S&P be at the end of the year? I don’t know.
-Where will the 10-year yield be at the end of the year? I don’t know.
-Will Crude Oil be higher or lower a year from now? I don’t know.
-Is Gold or Bitcoin a better investment here? I don’t know.
-When will the elevated inflation rate come back down? I don’t know.
-Will the U.S. enter a recession next year? I don’t know.
-What will be the best performing stocks/sectors/asset classes over the next day/month/year? I don’t know.
-How many times will the Fed hike rates over the next year? I don’t know.
You diversify because you don’t know the answer to these questions. No one does.
As an investor today, you don’t know if the current bull market will end this year or continue for a few more years. You don’t know if U.S. stocks will continue to crush international/EM in the years to come or finally start to lag. You don’t know if the 40-year secular bull market in Treasury bonds ended in 2020 or if yields will turn down once more. You don’t know how many times the Fed will hike rates and what impact that will have on markets and the economy. You just don’t know.
In any given year, predicting which asset class will be at the top and which will be at the bottom of the performance rankings is a fool’s game (see table below). No one can do it with any consistency.
In fact, just the opposite is more often true. Admitting you know nothing is the most likely path to wealth as it will push you towards long-term compounding and diversification (higher probability outcomes) and away from making overconfident short-term bets (lower probability outcomes).
So the next time someone ask you where the markets are headed, don’t be afraid to say “I don’t know.” In the business of investing, it’s the most honest and helpful thing you can say.
“It ain’t what you don’t know that gets you into trouble. It’s what you know for sure that just ain’t so.” – Anonymous (often misattributed to Mark Twain)
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