This time in my ”MTEA series” i reflect on the emotion confidence. Let’s start by looking what our friend Wikipedia states about it:
”Confidence is a state of being certain
either that a hypothesis or prediction is correct or that a chosen course of
action is the best or most effective. Confidence comes from a latin word
fidere’ which means ”to trust”; therefore, having a self-confidence is
having trust in one’s self.” (Wikipedia: ”confidence”)
I would add
that confidence is typically tied to ”doing”. This is easier to explain with
the help of self-confidence. One can develop a great self-confidence by doing
things and succeed in that doing. For example i used to swim (in competitions)
when i was a kid and when i practiced, i got better and i managed to improve my
lap times and this contributed finally to better self-confidence. It is worth
to point out, that good self-confidence doesn’t necessarely come hand in hand
with good self-esteem. On the contrary, i have seen it in myself and in many
other people, that one can have a combination of good self-confidence and poor
self esteem. Self esteem is tied to ”being”: how do i feel about myself as a
human being (not as a human doing).
Then, what are
particularly interesting consepts in investment world are the ”derivatives of
confidence” which are also called cognitive biases: over- and under-confidence.
American Psychological Association’s dictionary defines those as:
Under-confidence: a cognitive bias characterized by an underestimation of one’s ability to
perform a task successfully or by an underrating of one’s performance relative
to that of others.
Over-confidence: a cognitive bias characterized by an overestimation of one’s actual
ability to perform a task successfully, by a belief that one’s performance is
better than that of others, or by excessive certainty in the accuracy of one’s
beliefs.
Especially
over-confidence is widely recognized bias in the capital markets. Probably the most
famous researcher of overconfidence (among many other things) is the nobel-winner
Daniel Kahnemann who has said about the bias:
- ”We are prone to overestimate
how much we understand about the world and to underestimate the role of chance
in events.”
- ”Declarations of high confidence
mainly tell you that an individual has constructed a coherent story in his
mind, not necessarily that the story is true.”
Furthermore,
Larry Swedroe (from the ”evidence based investor” web page) summarizes some
known characteristics regarding over-confidence that Kent Daniel and David Hirshleifer have written in their piece
called ”Overconfident Investors,
Predictable Returns, and Excessive Trading”:
- ”People
tend to be over-optimistic about their life prospects, and this optimism
directly affects their final decisions.”
- ”Overconfidence
has been documented among experts and professionals, including corporate
financial officers as well as professional traders and investment bankers.”
- ”Overconfidence
includes over-placement (over-estimation of one’s rank in a population on some
positive dimension) and over-precision (over-estimation of the accuracy of
one’s beliefs). An example is the overestimation of one’s ability to predict
stock market returns.”
- ”A
cognitive process that helps support overconfident beliefs is self-attribution
bias — people credit their own talent and abilities for past successes while
blaming their failures on bad luck. Self-attribution bias allows overconfidence
to persist. When investors “get it right,” they upgrade their confidence in
their beliefs; when they “get it wrong,” they fail to downgrade it.”
- ”Men
are more overconfident than women in decision domains traditionally perceived
as masculine, such as financial matters. Overconfidence leads to more trading.
One study found that, consistent with higher confidence on the part of men, the
average turnover for accounts opened by men is about 1.5 times higher than for
accounts opened by women, and as a result, men pay almost one per cent per year
more in higher transaction costs and their net-of-fee returns are far lower.”
To sum up,
over-confidence is widely acknowledged phenomenom in the financial markets and
it can sabotage one’s trading records. Under-confidence is not an optimal angle
in investing – and in life in general – either. One bumps into under-confidence
bias more in the self-help literature where all kinds of books try to help
people getting more confidence. So we are easily getting mixed signals: are we
too over- or underconfident? And is there some ”right amount of confidence”
that i could try to target? PhD Don A. Moore says there is. He says:
- ”There is a zone between too much and
not enough confidence. This Goldilocks zone of confidence is where
rational beliefs meet reality. It is fundamentally based on truth and
good sense. It is built on beliefs that can be justified by evidence and
honest self-examination. It steers between the perilous cliff of
overconfidence and the quicksand of underconfidence. It is not always easy
to find this narrow path; it takes honest self-reflection, level-headed
analysis, and the courage to resist wishful thinking.”
and furthermore:
- ”This middle way is not the path to
mediocrity—far from it. It is exceptionally rare to be well-calibrated in
one’s confidence. It requires that you understand yourself and what you are
capable of achieving. It requires that you know your limitations and what
opportunities are not worth pursuing. It requires that you act confidently
based on what you know, even if it means taking a stand, making a bet, or
speaking up for a viewpoint that is unpopular. But it also requires the
willingness to consider the possibility that you are wrong, to listen to
evidence, and to change your mind. This is a rare combination of courage and
intellectual humility, which leads to actively open-minded thinking. It takes
just the right amount of confidence.”
I wrap up
this story by listing few things that i have found useful when working on my ”right
amount of confidence”:
- try
to work on your self-awareness and consciousness and in this case particularly regarding
confidence: are you typically over- or underconfident; and in what areas of
life these biases typically exist? It might be good to mirror that with
supervisor/coach/therapist to get honest and professional reflection; one’s
confidence level and biases are typically coloured by childhood experiences and
that makes this phase difficult
- Once
you are aware of your typical biases, you can start working to aim for optimal
level of confidence. For example with your over-confidence you probably need to
work with humility – ability to be more humble. That on the other hand requires
more work with your vulnerability.
- Observations
vs interpretations: are your thoughts based on observations or interpretations?
It is useful skill to work making observations rather than projected
interpretations. This helps you to make ”level headed analysis”. This process
impacts your thinking which impacts on your emotions and behavior. The more you
are able to make clean observations, the more likely you are also less biased
to false over-confidence.
So, confidence issue is pretty complex and multi faceted. Good thing is that it can be worked out and that might be very valuable investment for a trader, portfolio managers and others.
Aku