Capital Perspectives: Countering overconfidence bias

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Regular readers of this column know behavioral finance topics feature prominently because learning about cognitive errors and emotional biases, eliminating them where possible and accommodating them where they are not, can be an investment edge.

Cognitive errors (e.g., illusion of control bias, hindsight bias and confirmation bias) are primarily due to faulty reasoning and can often be corrected or mitigated with better training. Emotional biases are not related to conscious thought and stem from feeling, impulses, or intuition. Therefore, while cognitive errors are important, since emotional biases are harder to coach out of our humanity, it behooves us to acknowledge their presence and structure investment processes designed to neuter them. While philosophies can be adopted in the abstract, the specific processes used must be customized to the individual given we all have a unique psychological makeup.

A recent column explored ways to counter the loss aversion bias in an investment process. Today we start a series on emotional biases as defined by Kaplan. Below the definition of the bias, I offer ideas on how to structure an investment process to mitigate its harmful impacts.

Overconfidence – investors exhibiting overconfidence believe that they can control random events merely by acquiring more knowledge and consider their abilities to be much better than they are. They take credit for any financial decisions that have positive results. Any negative outcomes are attributed to external sources.

Position size limitations are a reasonable method for working around overconfidence. For example, it is generally prudent to have cash on hand as dry powder to take advantage of opportunities as they arise. The question then becomes: How much cash is too much to have in an equity allocation? It is prudent to hold cash if you cannot find attractive stocks to buy. However, as cash builds, you eventually pass over into the imprudent game of trying to time the market. There is no rule for how much cash is too much, and some simply think you should stay fully invested all the time. However, it could be useful for an investor to think through this issue ahead of time and settle on an acceptable maximum cash balance that suits his preferences and objectives.

For example, consider an investor with 80% of her equity allocation invested in a few highly diversified investment funds. The remaining 20% is earmarked for individual stocks, and if she cannot find enough individual stocks to own in sensible size (Perhaps an individual stock position minimum is 1% for more speculative companies, with a typical maximum of 4% for blue chips.) to fill out 20% of the portfolio, she will hold some cash. Therefore, in an extreme scenario where there is not a single stock she felt compelled to own, the maximum cash position would be 20%.

In the above example the cash balance is driven by the availability of bargain purchases in individual stocks. This may result in a more objective process that mitigates the impulse to indulge one’s overconfidence and time the market.

Chas Craig is president of Meliora Capital in Tulsa (www.melcapital.com).

This column has been prepared by an employee of Meliora Capital, LLC. This column is for information and illustrative purposes only. It is not, and should not be regarded as investment advice or as a recommendation regarding any security mentioned herein. Opinions expressed herein are current opinions as of the date appearing in this material only and are subject to change without notice. Reasonable parties may disagree about the opinions expressed herein. The representations made in this column are based upon publicly available information and assumptions about future economic variables which may or may not be reflective of actual occurrences. Meliora Capital, LLC its employees or affiliates may have an economic interest in the securities identified herein.

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