8 Mistakes Most Money Managers Make: Mistake #3: Confidence Bias

It is easy to have high confidence in familiar names or where there is a high probability in your thesis playing out. But unless the probability of your thesis is 100 percent, you must force yourself to measure the loss associated with the counter thesis.


“Any individual decision can be badly thought through, and yet be successful, or exceedingly well thought through, but be unsuccessful, because the recognized possibility of failure in fact occurs. But over time, more thoughtful decision-making will lead to better overall results, and more thoughtful decision-making can be encouraged by evaluating decisions on how well they were made rather than on outcome.” - Robert Rubin, former Treasury Secretary

The Problem: There seems to be a general over-reliance on conviction level in position sizing. It is easy to have high confidence in names that you know well or where there is a high probability in your thesis playing out. But unless the probability of your thesis is 100 percent, you must force yourself to measure the loss associated with the counter thesis. Idea quality is a combination of conviction level in thesis, profit from thesis, and loss from counter-thesis. Each component should be weighed properly in determining the overall impact of the idea on the portfolio.

I consult with many portfolio managers to highlight inefficiencies in their portfolios and find the confidence bias to be pervasive. My first question for most managers is to explain the logic behind their largest position size in the portfolio. One conversation with a portfolio manager about his largest position shows the manifestation of confidence bias in detail.

When describing his largest position, he explained how his deep knowledge of the company and close relationship with management made him confident the company would beat earnings and rise at least 10 percent. When pressed to quantify his confidence, he said, “90 percent chance.”

I then asked what happens the other 10 percent of the time to which he responded by describing a scenario where the stock would be down 20 percent+ because the general consensus was that they would beat earnings. I did the quick math and showed that his biggest position only had a 7 percent risk-adjusted return.

The fund manager acknowledged the disconnect between the position size and risk-adjusted return and subsequently changed his position size. This is indicative of the problems of assessing idea quality through mental calculation and how conviction level can cloud the true risk-reward picture.

The Solution: The confidence bias would have been avoided by simply calculating a risk-adjusted return. Risk-adjusted return is the probability-weighted profit of being right in relation to the probability-weighted loss of being wrong. In the example above, conviction level had been over-weighted in the portfolio manager’s mental calculation of position size.

A firm can eliminate a great deal of confidence bias by requiring a probability-weighted estimate of profit and loss for each asset in the portfolio. This allows portfolio decisions to be made with a clear picture of expectations. The caveat being that risk-adjusted return is limited by the quality of the estimates. But, inferior research will lead to poor decisions with or without the use of risk-adjusted return, so it should be encouraged as a way to foster intellectual honesty and remove confidence bias.

Click here for the solutions to:

Mistake #1: Discounting the Downside

Mistake #2: The Good Stock Paradox

Mistake #4: The Value Trap

Mistake #5: Higher Return Does Not Always Mean Higher Risk

Mistake #6: What Is Your Sixth Best Idea?

Mistake #7: Position Overload

Mistake #8: The ETF Hedge (The non-Alpha Short)

Cameron Hight

Cameron Hight

Cameron Hight, CFA, is an investment industry veteran with experience from both buy and sell-side firms, including CIBC, DLJ, Lehman Brothers and Afton Capital. He is currently the Founder and CEO of Alpha Theory™, a risk-adjusted return based Portfolio Management Platform provider.