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These three words, almost never uttered in this business, are far and away the most critical to long-term investment success.
Because the future and markets are unpredictable, and having the humility to admit that is very hard for us to do. We’re simply not wired that way and instead suffer from the behavioral bias of overconfidence. Which is to say we overestimate our own abilities when it comes to sports, trading, driving or anything else.
While a little bit of confidence can be a good thing in many areas of life, overconfidence, particularly in the investment world, can be disastrous. With overconfidence comes the tendency to overtrade and make highly speculative, concentrated bets on the future.
Many studies have shown that these attributes tend to lead to lower overall returns (see, for example, Barber and Odean (1999)). The more confident you are, the more you trade, and the worse your returns are on average. And interestingly, as men tend to be more overconfident than women, they tend to have lower returns (see Barber and Odean (2000)).
What’s the best way for investors to manage their overconfidence?
Diversification. Not putting all of your eggs in one basket, resisting the urge to trade, and sticking with a broad asset allocation plan. Boring, I know; not nearly as exciting as letting it ride in some penny stock. I completely agree, but successful investing is not supposed to be exciting or entertaining. By diversifying, you’re removing your ego from the equation and accepting the fact that you’re not likely to pick the next Apple or make the next Big Short.
To the contrary, you are saying three important words when it comes to making precise predictions or forecasts about the future: I Don’t Know.
Let’s practice this concept in response to some standard questions you hear on TV every day:
Where will the S&P be at the end of the year? I don’t know.
Where will the 10-year yield be at the end of the year? I don’t know.
Where will Crude be a year from now? I don’t know.
Is Gold a good investment here? I don’t know.
Will the U.S. enter a recession this year? I don’t know.
What will be the best performing stocks/sectors/asset classes over the next day/month/year? I don’t know.
Will the Fed hike rates this year? I don’t know.
Who will win the election and what impact will it have on the economy/markets? I don’t know.
If I tried this know-nothing routine on TV they would never have me back on but as an investor it’s your best weapon. You diversify because in any given year you don’t know which asset class will be at the top and which will be at the bottom of the performance rankings (see table below). As an investor today, you don’t know if the 7-year expansion/bull market will end this year or continue for a few more years. You don’t know if U.S. stocks will continue to crush international/EM in the years to come or finally start to lag. You don’t know if the 36-year secular bull market in Treasury bonds is going to continue or if yields will finally begin to rise. You don’t know if the Fed will hike rates once, twice or not at all this year and what impact if any that will have on markets. You just don’t know.
But that’s alright, because as luck would have it “knowing” (or more accurately, thinking you know) the future is not a prerequisite to making money in markets. In fact, just the opposite is true: admitting you know nothing is just about the best thing you can do.
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This writing is for informational purposes only and does not constitute an offer to sell, a solicitation to buy, or a recommendation regarding any securities transaction, or as an offer to provide advisory or other services by Pension Partners, LLC in any jurisdiction in which such offer, solicitation, purchase or sale would be unlawful under the securities laws of such jurisdiction. The information contained in this writing should not be construed as financial or investment advice on any subject matter. Pension Partners, LLC expressly disclaims all liability in respect to actions taken based on any or all of the information on this writing.
Charlie Bilello is the Director of Research at Pension Partners, LLC, an investment advisor that manages mutual funds and separate accounts. He is the co-author of four award-winning research papers on market anomalies and investing. Mr. Bilello is responsible for strategy development, investment research and communicating the firm’s investment themes and portfolio positioning to clients. Prior to joining Pension Partners, he was the Managing Member of Momentum Global Advisors previously held positions as an Equity and Hedge Fund Analyst at billion dollar alternative investment firms.
Mr. Bilello holds a J.D. and M.B.A. in Finance and Accounting from Fordham University and a B.A. in Economics from Binghamton University. He is a Chartered Market Technician (CMT) and a Member of the Market Technicians Association. Mr. Bilello also holds the Certified Public Accountant (CPA) certificate.
You can follow Charlie on twitter here.
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