What is the most effective strategy for investors to deal with their overconfidence bias?
1) Diversification refers to avoiding putting all your eggs in one basket.
2) Avoiding the temptation to trade (first, do no harm).
3) Maintaining a broad-based asset allocation strategy.
I know, it’s boring; it’s certainly not as thrilling as letting it ride in the newest speculative craze. I agree totally, but good investing isn’t supposed to be fun or exciting. By diversifying your portfolio, you’re removing your ego from the equation and acknowledging that you’re unlikely to pick the next Apple/Amazon or make the next Big Short.
On the contrary, whenever it comes to making precise forecasts about the future, you are saying three key words: I’m not sure.
Let’s put this concept to the test by answering some common questions you hear on financial television every day:
-Will the S&P 500 be higher or lower at the conclusion of the year? I’m not sure.
-At the end of the year, where will the 10-year yield be? I’m not sure.
-Will the price of crude oil be higher or lower in a year? I’m not sure.
-Would it be preferable to invest in Gold or Bitcoin in this case? I’m not sure.
-When will the high inflation rate start to fall? I’m not sure.
-Will the United States go into recession next year? I’m not sure.
-What stocks/sectors/asset classes will have the best performance over the next day/month/year? I’m not sure.
Because you are unsure of the answers to these questions, you diversify.
As an investor, you have no way of knowing if the current bull market will expire this year or last a few more years. You have no idea whether U.S. stocks will continue to beat international/EM stocks in the coming years or if they will ultimately start to lag. You don’t know if the Treasury bond market’s 40-year secular bull market will expire in 2020 or if yields will fall again. You have no idea how many times the Fed will raise rates or how this will affect markets and the economy. You simply have no idea.
Predicting which asset class will be on top and which will be at the bottom of the performance rankings in any given year is a fool’s game (see table below). It’s impossible for anyone to accomplish it consistently.
But that’s well; as fate would have it, “knowing” (or, more properly, “believing you know”) the future isn’t a requirement for profiting in the markets.
In fact, the opposite is typically the case. Admitting that you don’t know anything is the most likely path to wealth, as it will encourage you to focus on long-term compounding and diversification (higher probability outcomes) rather than overconfident short-term wagers (lower probability outcomes).
So don’t be scared to respond “I don’t know” the next time someone asks you where the markets are headed. It’s the most honest and helpful thing you can say in the investment world.
“It ain’t what you don’t know that gets you into trouble. It’s what you know for sure that just ain’t so.”ANONYMOUS (OFTEN MISATTRIBUTED TO MARK TWAIN)