Two Types Of Overconfident Investors
I started investing in individual stocks shortly after the Great Financial Crisis ended in 2009. I picked an investing strategy that closely resembled the Dogs of the TSX, buying the 10 highest yielding Canadian dividend stocks. As you can imagine, the share prices of these companies got hammered during the stock market crash so I was able to scoop up shares in banks, telecos, pipelines, and REITs on the cheap.
Stocks came roaring back right away and my portfolio gained 35% by the end of 2009. Investing is easy, right?
It took me a while to figure out that my portfolio returns had less to do with my stock picking prowess and more to do with market conditions, luck, and the timing of new contributions. The rising tide lifted all ships, including my handful of Canadian dividend stocks.
I started comparing my returns to an appropriate benchmark to see if my judgement was adding any value over simply buying a broad market index fund. My portfolio outperformed for a few years until it didn’t. In 2015, I had enough and switched to an index investing strategy. Now I invest in Vanguard’s All Equity ETF (VEQT) across all of my accounts.
Related: Exactly How I Invest My Money
New investors who started trading stocks in the past 18 months have likely had a similar experience. Stocks crashed hard in March 2020, falling 30%+ from the previous month’s all-time highs. Since then markets have been on an absolute tear. The S&P 500 is up 91% from the March 2020 lows. The S&P/TSX 60 is up 70%.
That’s just country specific market indexes, mind you. Since March 2020 individual stocks like Facebook and Apple are up 137% and 155% respectively. Tesla is up 700%. Meme stock darlings AMC and GameStop are up 1,045% and 3,621% respectively.
No doubt, unless they’ve done something disastrous, new investors participating in this market have seen incredible returns so far.
This can lead to overconfidence – when people’s subjective confidence in their own ability is greater than their objective (actual) performance.
Overconfident Investors
Larry Swedroe says the biggest risk confronting most investors is staring at them in the mirror. This is the first type of overconfident investor.
Overconfidence causes investors to trade more. It helps reinforce a belief that any investment wins are due to skill while any failures are simply bad luck. According to Swedroe, individual investors tend to trade more after they experience high stock returns.
Overconfident investors also take on more uncompensated risk by holding fewer stock positions.
Furthermore, overconfident investors tend to rely on past performance to justify their holdings and expectations for future returns. But just because stocks have soared over the past 18 months doesn’t mean that performance will continue over the next 18 months.
In fact, you should adjust your expectations for future returns – especially for individual stocks that have increased by 100% or more. No stock, sector, region, or investing style stays in favour forever. If you tilt your portfolio to yesterday’s winners (US large cap growth stocks) there’s a good chance your portfolio will underperform over the next decade.
The second type of overconfident investor is one who makes active investing decisions based on a strong conviction about how future events will unfold.
Related: Changing Investment Strategies After A Market Crash
Think back to the start of the pandemic. As businesses shut down around the world it seemed obvious that global economies would suffer and fall quickly into a massive recession. The stock market crash reinforced that idea. Investors hate uncertainty, but this time it seemed a near certainty that stock markets would continue to fall and remain in a prolonged bear market.
Markets quickly turned around as central banks and governments doled out massive stimulus to keep their economies afloat and their citizens safe at home. Now it became ‘obvious’ that investing in sectors like groceries, cleaning supplies, online commerce, and video technology would produce strong results.
Fast forward to today and the biggest concern for investors is high inflation. Some investors, overconfident in the outcome of sustained higher inflation, have shifted their portfolio into so-called inflation hedges. These could include gold, cryptocurrency, inflation-protected bonds, commodities, or real estate.
But as Ben Felix pointed out in this episode of the Rational Reminder podcast, the ultimate inflation hedge is a globally diversified and risk appropriate portfolio (and even that’s not really a hedge).
Finally, there are the perma-bears who claim the next great crash is right around the corner. These overconfident investors aim to avoid losses and protect their downside by making active bets with their portfolio. This could include selling stocks and moving to cash, using alternative investments that have low correlation to stock performance, buying put options, or short selling stocks.
The point is, they know what’s coming and how to avoid it.
One notable Canadian advisor has been calling for investors to get out of the market since last April. To him, the recovery was a mirage masked by government spending. Valuations were too high to support further growth, and therefore not just a crash but the biggest crash since the 1930s was coming soon.
Reasonable critics (like me) would agree that stock valuations, especially US stocks, are high. We would agree that there’s always the possibility of a stock market crash. What we disagreed with is what to do about it. If you’re invested in a globally diversified and risk appropriate portfolio, the answer is to lower your expected future return assumptions and do nothing else.
Ahhh, we finally know why a certain advisor has been screaming from the rooftops about a market crash since March 2020. He actually bet on it pic.twitter.com/vyK5wYhEdo
— Boomer and Echo (@BoomerandEcho) August 18, 2021
Or you could do that ¯\_(ツ)_/¯
Final Thoughts
Overconfidence is something that most investors have to deal with at some point in their journey. I argue that there are actually two types of overconfident investors.
The first type is when you believe your past investing performance has more to do with your skill and decision making than with luck, timing, and market conditions.
The second type is when you believe you can correctly predict a future (macro) outcome and you make active decisions with your investments to support that belief.
You can avoid the first type of overconfidence by diligently comparing your investment returns with an appropriate benchmark index. I did this with my Canadian dividend stocks by comparing the performance to the iShares Canadian Dividend Aristocrats Index ETF (CDZ).
This process helped open my eyes to how difficult it is to actually beat the market on a consistent basis. I eventually gave up stock picking and switched to indexing – accepting market returns in exchange for a tiny fee.
The second type of overconfidence is much more difficult to overcome. We can’t help but make predictions about the future, or listening to pundits who make a living sharing their predictions. Even if we don’t have strong convictions about the future, we can easily be swayed into doing something with our investments to stickhandle around future outcomes.
This is where I find comfort investing in an asset allocation ETF. When I invested in individual stocks I could see plain as day which ones were in the red (looking at you, oil & gas stocks). Even with a multi-ETF portfolio you can see which one(s) are underperforming and you can easily second guess your holdings or target asset mix.
With an asset allocation ETF you don’t see the underlying holdings. It all moves together in a perfectly balanced and targeted mix. This way, I find myself less likely to want to tinker with my portfolio when it’s all rolled up into one investment.
My first thoughts about what to do about high stock valuations were the same as yours: “If you’re invested in a globally diversified and risk appropriate portfolio, the answer is to lower your expected future return assumptions and do nothing else.” Then I thought about what I’d do if P/E values kept rising to 40, 50, or beyond. As a retiree, at some point I’d lighten up on stocks to reflect the fact that I simply wouldn’t need much in the way of future returns because I’d “won the game.” I decided to quantify how much of my stocks I’d sell. I now have a formula in my spreadsheet. At current P/E levels it has my fixed-income allocation raised from 20% to 24%. So, for now, rather than “nothing else”, I’m doing “almost nothing else.”
Hi Michael, that’s a fair point. Plus, if stock valuations continued to rise to those levels then I’d assume you would be doing regular rebalancing along the way.
Your comment about having won the game is important, too, because most investors think in terms of ‘more’ and wouldn’t consider lightening up on stocks simply because they have enough assets and should be taking risk off the table.
I realize that I’m an unsophisticated investor and started my journey with Couch Potato and navigated the TD eseries . Now I’m going the ETF Vanguard route thanks to finding Rob. The market crash in March 2020 shook my confidence but I stayed put however it has made me realize with 5 years away until retirement for my husband and I. Myself with pension and him self employed that I need to become more educated on what is the best move forward and simple works for me. I think this book would benefit me tremendously.
Wow! Your post couldn’t be timed any better Robb. We started investing in stocks about the same time as you. Prior to that we where in GIC’s primarily. We have done well although the crash in 2020 scared the crap out of me. We are still all in individual stocks but I have to make some changes as we are getting older. (74 & 72). Thank you for the post!
Hi Gary, thanks for your comment. I think your timing as a stock picker was likely a blessing and a curse. A blessing because we’ve been in an incredible bull market since 2009 with few interruptions (although a big one in 2020). A curse for the reasons I explained in this post.
It’s not always easy to make changes to your investment approach after so long but know that you can do this relatively pain-free in your RRSPs and TFSAs. Taxable accounts can be a bit of a challenge, though.
For sure I fall into this category, at least to some degree. I also “rebooted” my investing strategy with the Dogs of the TSX / BTSX strategy beginning in January 2020. My first tranche obviously stunk the joint out, but I was fortunate enough to have other resources to invest right through to January 2021. Along the way I made a few other picks – high dividend payers (+8%). Today I accept those choices may give me a great monthly dividend but not great longer term growth (and possibly negative growth).
The right decision is to part ways with those 2 investments, but choosing something that might give 1/2, or less than 1/2 of the dividend I get today is not an easy choice!! I’m just going to have to pull the trigger at some point.
Hi James, thanks for sharing. Remember, there’s nothing special about dividends. It’s an investment’s total return that matters. An 8% dividend yield is likely not sustainable.
This is a great post. Thanks for sharing it Robb.
I like it because DIY investing is actually a lot tougher than people realize. The more you follow the day to day, which would be necessary to spot any good opportunities, the more emotional it is.
In a sense you have to be very educated about possible behavioural traps so that you don’t become a casualty to a “good story”.
As someone who “sins” a little with individual stocks but is mostly in ETFs, I have seen that I have been lucky. It has led me to chase returns once or twice. But I have found that I have to be very disciplined to have this strategy not to take over my entire portfolio.
Robb, other than time (decades spent as a DIY investor), how have you best learnt and applied not behavioural finance. Love to hear your tips on or NOT screwing yourself over.
Love to hear your thoughts,
Braden
Hi Braden, thanks for your comment and the kind words. I’ve done a lot of reading on behavioural finance and it was Daniel Kahneman’s Thinking, Fast and Slow that first got me thinking about my own investing behaviour. From there I’ve read Richard Thaler and Dan Ariely, who probably have the best insights into behavioural finance.
There’s decades of academic and empirical research that shows how active management through mutual funds or stock picking is a loser’s game after fees, and that investing passively in broad market indexes gives you the best long-term outcomes.
The emergence of blogs and podcasts with experts who can communicate these ideas clearly to the average investor has helped tremendously. I’m thinking of Canadian experts like Dan Bortolotti and Justin Bender, Preet Banerjee, Ben Felix and Cameron Passmore, and Michael James who commented above.
The more we can communicate these ideas to the average investor in clear, actionable, and plain language terms the better off they’ll be.
Finally, in my own fee-only advice practice and in communicating with blog readers I have learned how valuable it is to have a simple strategy. I’d argue it’s as important as keeping costs low and diversifying globally. Investors really trip themselves up trying to optimize their portfolios with complicated multi-product strategies (that goes for stocks and ETFs). Unless you enjoy living your life in a spreadsheet, and some people do, then sacrifice a few basis points of fees and just go with a one-fund solution or a robo advisor.