Many of the decisions that investors typically make are way beyond their circle of competence. That’s the view of GREG DAVIES, Head of Behavioural Finance at Oxford Risk.

In this interview, Gregg addresses two of the most prevalent behavioural biases investors are prone to — overoptimism and overconfidence — and argues that investors need to be much more realistic about which decisions they are sufficiently competent to make.

Greg’s specialist expertise is in improving financial decisions through behavioural science. As well as holding a PhD in Behavioural Decision Theory from the University of Cambridge, he’s an Associate Fellow at Oxford’s Saïd Business School and a lecturer at Imperial College London.

 

Greg Davies, in your view, how much of a problem do overoptimism and overconfidence pose to investors?

A lot of investors could be characterised as passive-aggressive. They’re passive in the sense that they leave far too much of their wealth doing nothing for far too long, and with the wealth that they do put into the market, they are aggressively trying to do something to it at any given moment. When you’re trying to do something to your investments, then overconfidence and overoptimism becomes a problem.

We all start to believe our own stories. For example, I read something in the newspaper, it resonates with me, I ascribe to it immediate and great confidence, and so I act on it. If we’re overconfident, we’re acting on stories that we shouldn’t be acting on, where we simply aren’t justified in having that level of confidence to do anything.

You mentioned newspapers there. To what extent are these behaviours encouraged by what we read in the media?

We ascribe information to things that we want to believe, so things that resonate with us we will start to believe more and more in. People will pick up and listen to all manner of things, including horoscopes at the extreme. No one ever acts, by the way, on numbers; no one buys return trade-offs. What we buy are stories, and stories come with a degree of comfort attached to them. If I have a story that is intelligible to me, if I understand it, if it just seems intuitively right, then it creeps past my guard, and the minute it is past my guard, it becomes something that I’m comfortable believing and something that I want to believe and so I become overconfident in it.

How then should investors view fund or share tips or other recommendations they read about in the money pages or on the internet?

If you were to look at all the possible decisions in front of you, some of them will be things where you genuinely have the knowledge to tell whether it’s a good or a bad decision. Warren Buffett talks about things being within your circle of competence. But some of the decisions in front of you will not fall in your circle of competence. They will be on the fringes of your competence. You might think you know something about them.

The more decisions you make, the larger the proportion of decisions that aren’t going to be in your core sphere of competence. They’re basically decisions in which you’re just going to be rolling the dice. If we’re trying to make good decisions in investing, after fees and after all the noise in the markets, we shouldn’t be rolling the dice on marginal things. We should be acting only where we really have confidence and competence.

A simple solution, surely, is for investors to make fewer decisions and just do less?

Depending on who you talk to, people will have a different answer to the question, How much should you trade to do well in the markets? There are people at one end of the spectrum who will say their favourite holding period is for ever, and here are some people who think you have to trade a lot. Wherever you are on that spectrum the right answer is less than you think it is. However much you are inclined to do, a sensible investor always does less than that.

The problem is though that it can be very tempting to try to time the market. It’s sometimes very hard to do nothing.

When markets are going up and down, it normally feels uncomfortable for us to do nothing, not to react when it seems intuitively right to do so — for example, when the market is falling and you want to get out. It’s actually very difficult for us not to act on those sorts of things. The fact is though that this is the area where overconfidence manifests itself most extremely — our tendency to think we know where things are going next. In any short or medium time frame, the simple answer is that we do not know.

The simple answer is, don’t do it. Focus on time in the market rather than timing the market. But it’s one of those things that’s simple but not easy. It’s simple to say it, but when it comes to that moment, it’s normally very emotionally uncomfortable for us not to act on what we feel to be strong information, so we jump in.

There’s an example from animal behaviour, isn’t there, that you like to use to illustrate the value of staying in the market. Talk us through that.

Yes, it’s from a study involving pigeons. You put the pigeons in a cage and they learn to peck a red light or a green light. When they peck the red light, it delivers food with a probability of 40%, and when they peck the green light, it delivers food with a probability of 60%. So these pigeons start to do things we see humans do. It’s what’s called probability matching. They actually peck the green light more, because they get the food more frequently. They peck the green light 60% of the time and the red light 40% of the time.

That seems all very smart and clever until you realise you that the optimal strategy is to peck the green light all of the time. Now, interestingly, that 60:40 gap is about the same as you would expect to see major equity indices posting on a monthly basis. About 60% of months the index goes up and about 40% of months it goes down. If we could predict which months it’s going to go up or down, it would be rational to switch between being in the market and out of the market. The fact that we can’t means that we should just keep pecking the green light, because that is the most rational thing to do, unless you have a crystal ball.

 

Greg Davies is one of the experts featured in our video series, Your Own Worst Enemy. If you haven’t watched it yet, you can catch up here.