Cockiness v. cautious confidence

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Dan Richards is president of Strategic Imperatives. He is a faculty member in the MBA program at the Rotman School at the University of Toronto. He also hosts a weekly conference call called Monday Morning Jump Start, which is about strategies for financial advisors. Advisors can see it GlobeAdvisor.com. He can be reached at richards@getkeepclients.com

Of all the pitfalls for unwary investors, perhaps none is costlier than the wild fluctuations between two mindsets: absolute confidence in our investment strategies on the one hand; and on the other, periods of complete lack of confidence that the market will ever make money again.

Of these mindsets, overconfidence is more common - and the source of the highest profile blowups.

Overconfidence caused math PhDs with stratospheric IQs to build can't-miss models that have cost investors billions in the subprime fiascos and derivative disasters - think of the Nobel laureates at hedge fund Long Term Capital Management who almost brought the global financial system to its knees in 1998.

Overconfidence caused U.S. consumers to pile on leverage to buy huge homes they didn't need and couldn't afford.

Overconfidence kept investors concentrated in tech sector hot stocks in 2000 and in oil and bank stocks in early 2008 - fuelled by conviction that the world had changed and that tech, oil or bank stocks were the only place to be.

It's this same overabundance of confidence that causes company executives to invest the bulk of their net worth in shares of their company and sometimes competitors - they know their company and industry so well, why on earth would they invest elsewhere? They believe this with religious fervour - right until an out-of-the-blue event brings the entire industry to its knees.

Along similar lines, overconfidence is what leads investors to resist diversifying into investments that have underperformed, even if those investments would cushion their portfolio against future declines. After all, if I am absolutely confident in the future performance of my investments, why would I need to diversify?

Overconfidence in our daily lives

Overconfidence isn't just limited to investing, of course - New York Times columnist David Brooks recently wrote about how it permeates our lives.

Mr. Brooks pointed out that researchers have found that 94 per cent of college professors say that their performance is above the norm.

Of drivers, 90 per cent consider themselves above average.

And when computer executives were given a quiz about the industry, they estimated afterward that they had got 95 per cent of the answers right - when in fact their accuracy was 20 per cent.

And it isn't just mid-level managers who suffer from overconfidence - the field is littered with chief executive officers who were absolutely convinced of their genius and of the brilliance of the strategy crafted by the high-priced consultants they'd hired, right until that strategy cratered and their company went off a cliff.

Part of the reason for overconfidence is that it's human nature to remember when we're right and forget when we're wrong. Michael Nairne, CEO of Tacita Family Office, points out that weather forecasters and bookmakers rank among the experts who are closest to the mark when it comes to assessing their accuracy - largely due to the fact that they get immediate feedback on their predictions.

Avoiding overconfidence

To address this, some of today's very best money managers draw inspiration from Only the Paranoid Survive, the best-selling book of Intel co-founder Andy Grove.

These managers borrow from Mr. Grove's thesis that we need to be constantly alert for signs of complacency and overconfidence. After identifying the reasons that a stock will do well, these money managers step back and spend a great deal of time on the equally important question, "What can go wrong here?"

For the same reason, many veteran managers look for a margin of safety in the stocks they buy - to protect them against unanticipated and unpredictable events that can sideswipe even the best researched stocks.

And good money managers sit down at least once a quarter and focus on where every stock they own stands - looking especially hard at the assumptions that led them to buy the losers.

One seasoned money manager I talked to recently put it this way: "The more time I spend in this business, the more I realize how much I don't know. When I started managing money, self doubt was seen as a sign of weakness. With age and experience have come humility - I now recognize in a way that I never could have 30 years ago the knack that the market has of punishing conceit and cockiness."

The other end

of the pendulum

At the other end of the extreme from overconfident investors are those who have lost every shred of confidence - often causing them to flee into cash and guaranteed investment certificates (GICs), even when these pay next to nothing and those investors need the returns to hit their goals that only volatile stocks can provide.

That's exactly where many investors were earlier this year - at a time when it really did feel like the world was coming to an end and we were assaulted day after day by apocalyptic headlines. It was difficult for many investors to summon up any level of confidence.

And when they do decide to invest, many of these investors adopt an all-or-nothing approach, from being all in cash to all in stocks, and sometimes in super volatile stocks in the energy sector to boot.

Find the happy medium

For most Canadians, successful investing is about finding a happy medium between too much confidence and not enough.

You need to find a happy medium between plunging into stocks with abandon on the one hand and cowering on the sidelines on the other - by finding the right balance of investments to hold and sticking to it, no matter how rosy or gloomy the outlook might be.

And find the happy medium between giving no thought whatsoever to what can go wrong when making an investment on the one hand - and being so consumed by what can go wrong that you never end up investing on the other.

Given markets over the past year, many investors are taking a hard look at changing money managers or financial advisers. If you're among those looking for a new adviser, consider adding humility to the list of things you look for - that attitude of cautious confidence and "knowing what they don't know" could be one of the most important qualities your adviser brings.