When asked to rate their driving skills1, more than 75% of Americans believed they were in the top one third of the population. In international math competitions, American students routinely ranked themselves near the top of all countries participating even when not being in the top 10. This is somewhat natural and is not unique to just Americans. People tend to rank themselves above average on just about all favorable traits.
This is the Lake Wobegon effect, named after a fictional town in Garrisson Keillor’s satire where all men are strong, the women are good-looking and all children are above average. But we know that not all men can be equally strong. Some will be less strong, some will be more and a big chunk of them will have average strength. Same with the women and children. A statistically impossible town like Lake Wobegon cannot exist. But poll their residents and a majority of them will rate themselves above average on pretty much everything that is good.
This overconfidence bias naturally extends itself to investing. Zvi Bodie and Rachelle Taqqu write about this in Risk Less and Prosper on how pervasive this bias is, especially during bull markets, causing investors to underplay the risks they are taking.
In many cases, what looks like risk-taking is not courage at all, it’s just unrealistic optimism. Courage is willingness to take risk once you know the odds. Optimistic overconfidence means you are taking the risk because you don’t know the odds. It’s a big difference.
Optimism can be a great motivator. It helps especially when it comes to implementing plans. Although optimism is healthy, however, it’s not always appropriate. You would not want rose-colored glasses on a financial advisor, for instance.
Risk Less and Prosper by Zvi Bodie & Rachelle Taqqu
The authors also write that excessive optimism helps explain the popularity of stocks-for-the-long-run doctrine. The pseudo-factual statement that stocks always do well in the long run provides an overconfident investor with more grist for the optimistic mill.
But stocks for the long run only works when you have boundless resources and a plan to leave behind a dynasty for the ages. Because when you are not touching the invested principal, market losses become a sideshow.
But for the rest of us, an extremely long-run standard does not suit our finite assets or mortal lives. As John Maynard Keynes once said, the markets can stay irrational longer than you can stay solvent. Markets rise and markets fall, but it is a folly to assume that they’ll hit their best averages in perfect rhythm with your own explicit needs.
So instead of placing your faith in the potential of an indefinitely long run, a more dependable choice is to focus on the needs of your one very particular run. But by default, we resort to an investment choice of convenience like the target-date funds we find in our 401(k) plans. We have talked about their flaws before but to summarize, these funds universally assume that the stock and bond markets will behave precisely in tune with your very own lifecycle. They won’t.
Target-date funds or other age-based strategies don’t solve the problem because they may be locking in big losses at just the moment when they are switching from stocks to bonds.
Risk Less and Prosper by Zvi Bodie & Rachelle Taqqu
Larry Swedroe of Buckingham Strategic Wealth says that investors should evaluate their risk tolerance by considering their ability (financial capacity, investment horizon), willingness (emotional comfort) and need (required returns to meet goals) to take risks. This goes back to the amount of income you need to support your lifestyle in retirement. That then defines on a spectrum the amount of risk you need to take. And it is a spectrum based on pure, unadulterated number crunching.
Your ability to take risk is entirely different from how you feel about risk. Risk capacity is an objective measure that reflects how much money you can afford to lose, even in a worst case, without impairing your minimal goals. But how you feel about risk is subjective.
Risk Less and Prosper by Zvi Bodie & Rachelle Taqqu
And it helps to have a straightforward, no-nonsense plan with an unwavering ability to stick to it through thick and thin.
In combating overconfidence and excessive optimism, it helps to have a straightforward plan and stick with it. That means avoiding excessive trading. Hyperactive buying and selling by individuals is costly. Not only do you rack up high transaction costs this way, but there is no evidence that anyone has the clairvoyance to time markets.
Risk Less and Prosper by Zvi Bodie & Rachelle Taqqu
Thank you for your time.
Cover image credit – Riccardo, Pexels
- I Am a Better Driver Than You Think: Examining Self-Enhancement for Driving Ability by Michael M. Roy and Michael J Liersch ↩︎