Cognitive Biases Part 2-Optimism Bias

Another output of the herding and groupthink behaviour within the investing domain revolves around the unbridled optimism we have towards all of our investments. As investors, we believe that every stock, bond, mutual fund, and ETF we own is greatest investment in the world. Behaviorial economists call this the Endowment Effect. We’ve spent hours upon hours slicing and dicing companies and financial products and we have convinced ourselves that these assets we’ve invested in will lead us to the promise land. Then one day, some bad news comes out about one of our stocks. We don’t believe it. We don’t want to admit that our sacred stock has some warts on it. Even if it does have some flaws, we convince ourselves that the stock will come back.

The penguins of Wall Street and Bay Street get sucked into this don’t worry be happy type of behaviour. It’s reflected in their buy and sell recommendations (or should I say lack of sell recommendations) and also their enthusiastic earnings forecasts. Here are a couple of quick fingertip facts:

  • Only 5 percent of Wall Street Recommendations are “SELLS”, New York Times, May 15, 2008
  • Why Analysts Keep Telling Investors to Buy, New York Times, February 8, 2009
  • Equity Analysts Too Bullish and Bearish at the Exact Wrong Times, McKinsey, June 2, 2010
  • None of the S&P 1500 have a Wall Street Consensus “SELL” on them, Robert Power, Editor Retirement Weekly, August 2011.
  • Sources: Ritholz.com, McKinsey, Marketwatch

When we start looking to analyst earnings estimates, the giddiness goes to another level. According to a report from McKinsey, “analysts have been persistently overoptimistic for the past 25 years with earnings estimates (growth) ranging from 10 to 12 percent a year, compared with actual earnings growth of 6 percent…On average analysts forecasts have been almost 100 percent too high…”

Optimism + Group Think = Active Management

When you combine the herd/group think behaviour with unbridled enthusiasm you get the ingredients and environment for active investing. How well does active investing work? According to a study by Morningstar and Vanguard:

  • Only 20 percent of active managers (1 in 5) can outperform their benchmarks in any given year.
  • Within that quintile, less than half (1 in 10) outperform in 2 out of the next 3 years.
  • Only 3 percent stayed in the top 20 percent over 5 years (1 in 33)
  • Once we include costs and fees, less than 1 percent (1 in 100) manage to outperform their benchmarks

What are the odds you can pick that 1 in 100 manager? For an investor that is looking to invest for the next 20 to 30 years, those odds look pretty impossible.

The moral is it impossible to consistently outperform the overall stock market. It is possible however to earn a reasonable return that can cover the future loss of purchasing power and meet their long term goals.

Being confident that your investment decisions will pan out is not at all a bad thing. It’s a perfectly normal feeling to have. Being overconfident on the other hand can have more negative impacts as emotion is now entering the fray and often it can muddy our decision making. That’s why it is important to not fall in love with your investments as they can force us to hold investments much longer than we should. We should be setting exit points, where we can clinically sell a stock when it is crossing a certain loss threshold so emotion is kept at bay. Make no mistake about it. When you invest, you will make some bad decisions. Not everything will go according to plan or your analysis. It’s why it is important when evaluating stocks to always be critical and consider different, and alternative viewpoints so you are truly looking at all possible outcomes.