knowledge bank

Dec 15 2016
Lawrence Lam

Do we have as much foresight as we think?

Investors' mentality

Human nature makes us susceptible to biases when we make decisions. One such bias is the overconfidence bias, where investors have the potential to overestimate their ability to predict investment outcomes.

Our investing approach is about minimising the potential for bad investment decisions. To minimise the potential for overconfidence, we separate facts from perception by not focusing on forecasts, projections, or trends. We prefer to spend our time focusing on objective data based on today’s latest information.

A good investor knows they don’t know it all

Coming from an investment banking career, it is common to observe an abundance of self-confidence and conviction being portrayed by individuals in the industry. The certainty that is displayed in arriving at a decision often does not correspond with the level of available facts upon which a decision is made. Decisions are made quickly based on a significant body of subjective information and “gut feel”. Importantly, the overconfidence blinds these individuals – they are unconscious to the nature of their overconfidence. Nobel prize-winning Daniel Kahneman has written an excellent article on this topic: For investment bankers and other professionals that provide advice, this trait is favourable, as the client perceives an experienced, confident advisor with the conviction they so require.

However, advisors are distinctly different to investors, and to investors, this overconfidence is harmful.

Advisors have no money at stake – they are selling their knowledge and expertise to their clients. In contrast, investors have everything at stake. There are no prizes for investors who reach conclusions quickly based on subjective information. Investors are rewarded for being right, rather than being hasty. From our experience (more precisely, bad decisions) we know for a fact that we don’t know it all. During our decision-making process, we often find ourselves focusing on how we could be wrong rather than why our logic is correct.

How we balance the conviction required to invest whilst being aware of overconfidence bias – objective investing

As an investor, knowing that you don’t know it all can zap us of the very confidence required to reach an investment decision, so it is necessary to find a decision-making process that straddles the fine line between too much self-doubt and too much overconfidence. For us, we tread this fine line by minimising the potential for errors in judgement made through assumptions. Our investment analysis minimises the use of forecasting and favours the use of objective information. By maximising the use of factual data and minimising our own subjectivity, we know our own biases are minimised and our decisions are made objectively. This provides us with a solid foundation of confidence in our investment decision.

In our view, no one is able to predict the future consistently. Moreover, as an investor, attempting to predict the future is fraught with risk. Not only does one need to be correct in the magnitude of their forecast, but the Achilles heel for most investors engaged in the predictive arts, is timing. Even if one is correct at foreseeing the change in direction of a particular sector or company, it is near-impossible to pin point exactly when this change will occur. Investment performance is dependent on when returns are realised.

We have found that our time is better spent focusing on analysing the facts at hand, rather than estimating projections. Our considered investment approach is slow, but once we have considered all the facts and have reached a conclusion, we invest with conviction knowing that our process has minimised the potential for overconfidence.