“The combination of optimism and overconfidence is one of the main forces that keep capitalism alive.”
–Daniel Kahneman, (via Jason Zweig’s Thought of the Day)
Kahneman is the psychologist who won the Nobel Prize in Economics for his work on behavioral economics and the development of Prospect Theory. His book Thinking, Fast and Slow is a classic. I celebrate the optimism and overconfidence that causes entrepreneurs to take risks. This is the mechanism that allows capitalism to create greater wealth and well-being for all of society over time.
As for my personal investing style, I take a different lesson from this. Optimism and overconfidence in investing is a recipe for disaster, particularly the overconfidence part.
In his book The Missing Risk Premium, Eric Falkenstein talks about the anomaly that low-volatility stocks have outperformed higher-volatility stocks over several decades, with less risk. This completely blows up the financial academic models that link risk with reward, such as the Capital Asset Pricing Model.
Why should this be? Ego and overconfidence of investors, combined with the lottery ticket effect of skewness. We all like to think we are above average investors and we are concerned about the perceptions of others. It is just more exciting to own Tesla or some one-drug biotech that could be the next Apple or Google or whatever. It is pretty hard to brag at a cocktail party that you own an index fund or Johnson and Johnson. So people tend to swing for the fences with the hot, new, exciting names.
It is also hard to get people to hand you their money to invest if you are recommending boring index funds or low-volatility stocks. You have to sell your superior knowledge and skill that allows you to outperform, or at least make claims that you will. This is why professional money managers sell complex strategies that you couldn’t possibly understand or execute as well as they can.
Falkenstein’s blog post Ego and the Low Vol Premium reaches the following conclusion:
Our desire to impress others causes us to take too much risk. On the bright side, this implies some rather simple strategies like low volatility investing, because I don’t see it going away.
Now, I’m not wedded to a low-volatility strategy per se, but this knowledge informs my style of investing. I love to find boring high-quality businesses that are hard to brag about owning. If I can find them at a favorable valuation and all of my other requirements are met, I’m in hog heaven.
You need to ask yourself: why are you investing? Is it for bragging rights or to make good risk-adjusted returns? I’m firmly in the latter camp.