Investors have long drawn parallels between poker and investing. Although not perfect comparisons, there are many similarities between the two, largely stemming from the analogous interactions of psychology and probability with money.
There are some differences to consider, as well.
A great poker player will use statistics and other participants' behavior to separate his counterparts from their money. A successful financial services sector, on the other hand, should facilitate the effective and mutually beneficial flow of capital across the economy between savers, investors and businesses, hopefully at a fair price. In reality, though, the best compensated individuals on Wall Street often excel at separating market participants from their capital.
In poker, you may not always know if the other player is bluffing or not, but at least you always know he is on the other side of the deal. When hiring a financial advisor, consultant, or asset manager, you often cant distinguish either point.
Of course, to hear them tell it, every manager is always the best at what they do.
Come to think of it, my analyst must be the best scout in the world, because every single private-equity fund Ive ever met is top quartile. Or, maybe were not as good as we think we are at picking managers.
I recently read an article entitled Unskilled and Unaware of It: How Difficulties in Recognizing Ones Own Incompetence Lead to Inflated Self-Assessments, which was published in the Journal of Personality and Social Psychology in 1999. Authors David Dunning and Justin Kruger revealed some interesting tendencies regarding peoples perceptions of their own competence, tendencies that have distinct relevance for investors.
They created a series of tests measuring participants abilities in certain domains, such as humor, logical reasoning and grammar. The experiment measured the actual scores on the tasks, as well as participants perception of how they believed they scored.
The top performers across every test modestly underestimated their own performance. Second-quartile groups tended to accurately place themselves, while the third quartile moderately overestimated their results. Strikingly, participants in the bottom quartile on every test vastly overestimated their own competencies, sometimes by 500 percent! Despite scoring in the bottom of the pack, these individuals consistently ranked their performance as well-above average.
The effects of overconfidence on investing behavior have long been documented for professionals and amateurs alike. Dresdner Kleinwort Wasserstein published research demonstrating that roughly 75 percent of equity mutual-fund managers believe they are above average. (The remaining 25 percent deemed themselves average!) Terrance Odean at University of California, Berkeley has shown that overconfident investors trade more and earn less. And research published in the Journal of Finance on investment consultant recommendations showed that their investment manager picks underperformed funds they did not select. Worse, their top recommendations had even poorer performance.
While Charles Darwin sagely noted over a century ago, ignorance more frequently begets confidence than knowledge, the Dunning-Kruger effect showed the phenomenon is most prevalent amongst, and most detrimental to, those who are least competent. They lack both skill and the metacognitive ability to recognize their incompetence.
Context-specific knowledge helps in reducing the effects of overconfidence, so ongoing education about investment strategies and best practices for manager due diligence are a must.
And like many other cognitive biases, awareness of it is the best defense against the effects. Every time I meet a manager, Im acutely aware with near certainty that Im the least informed person in the room, and Im paranoid that Im the sucker. Thankfully, when youre paranoid that you are the sucker at the table, you play your cards a lot tighter.
This heightened awareness of our need for skepticism has resulted in an actionable takeaway that we incorporate into our due diligence: a conscious effort to intentionally underestimate returns and overestimate risk, the manager selection equivalent of playing a tighter hand. By underwriting every manager with a deliberately lower-return expectation, as long as it still meets the required cost of capital, we force a margin of safety into the process.
Underpromise + overdeliver = margin of safety.
At least thats the general idea, but Im not completely confident.
Christopher M. Schelling is the Director of Private Equity at the Texas Municipal Retirement System.