Here is an interesting chart from a study done in 2002 where two groups of professionals are asked to predict some near-term future outcome. One group of analysts are asked to predict the level of S&P 500 in the next month and half. Another group of weather men are asked to predict the average temperature in April for a location (about same one month and half time frame).
Each group are given three mutually exclusive and collectively exhaustive selections of greater than X, between X and Y, and less than Y. A sensible human being, from a mathematical perspective would have a confidence level of 33% (1/3 chance to be correct). Yet, the average level of confidence was about 58% for analysts and 49% for weather men, suggesting overconfidence in our ability may be a nature tendency.
What's more interesting is from the group of respondents that incorrectly predict the outcome. As a side note, about 1/3 of the analysts made the correct choice and about 2/3 of weather men did so as well. Participants who made incorrect forecast are asked for a reason for their inaccuracy. Interestingly enough, none of the analysts mentioned the outcome as lack of experience or insufficient data. Most attributed to the "single prediction" and “ceteris-paribus” defense mechanisms (definition below).
To be a better investor, I think it's more important to understand one's own emotional strengths and stay honest to one's own action than to crunching analysis. The issues mentioned here seems trivial but are very difficult to overcome. The following is a good checklist to remind our brain every once in awhile.
Optimism and Overconfidence:
- Optimism
Well documented trait among young individuals who feel the odds of something bad occurring in their lives are very low or even non-existent. Example: Young adults are far more likely to become disabled than they are of dying, yet the vast majority does not carry disability insurance.
- Overconfidence
People tend to place too much confidence in their ability to predict. They tend to systematically underestimate the risk, which lead to higher probability of surprises.
- Increased Trading
Belief that you can interpret information better than the average investors and often leads to undiversified portfolios.
- Overconfidence in Forecasters
Primary factor leading to overconfidence in professionals is knowledge (education or experience). They feel their forecasts are based upon skill (i.e., an illusion of knowledge)
Forecast defence mechanisms
1. The “if-only” defence.
2. The “ceteris-paribus” defence.
3. The “almost-right” defence.
4. The “it hasn’t happened yet” defence.
5. The “single predictor” defence.
Examples from financial-education.com:
“The “if only” defense says their forecast would have been correct if the advice or analysis they had provided had been followed. This defense is popular because it cannot be proven wrong since historical events will seldom follow a specific analysis. However, the basis of the original forecast was presumably to predict the likely outcome, not the outcome if a certain set of actions occurs. A conditional forecast should also outline the consequences of conditions varying from those set out.
The “ceteris paribus” defense says something interfered with the original forecast. “They would have gone bankrupt but their competitor bought them out.”
The “I was almost right” defense says the forecast almost happened. This applies primarily to averted catastrophes. “Long-term Capital Management’s collapse almost brought down the entire financial system.” If one was predicting the collapse of the financial system, close doesn’t count.
The “it just hasn’t happened yet” defense says the next hedge fund collapse will be the one that brings down the financial system. Either that, or the one following it.
The “single prediction” defense acknowledges that the conditions of the forecast were met but the prediction was still incorrect. However, forecasts are pointless so don’t hold it against the analysis that led to the forecast.”
Loss Aversion:
Individual’s reluctance to accept a loss. A stock may be down considerable from its purchase price, but the investor holds on to it hoping that it will recover. Loss aversion can also lead to risk-seeking behavior.
Reference:
Hersh Shefrin, Portfolios, Pyramids, Emotions, and Biases
James Montier, Behavioural Investing
Schweser CFA Level III Notes
http://financial-education.com/2007/09/09/ego-defense-mechanisms/
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