I
Don’t
Know
These three words, almost never uttered in this business, are far and away the most critical to long-term investment success.
Why?
Because the future is unpredictable, but 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 today:
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.
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