Are you a better driver than most people? Do you solve crossword puzzles faster? How about your talent for predicting the stock market—better than average?
If you answered “yes” to any of these questions then you are in the majority, according to many studies that have been conducted by behavioral psychologists in recent years.
The problem? Well, quite simply, as a matter of definition it’s impossible for a majority of people in any given pool to be above average in whatever it is that is being measured.
For example, in analyzing the skills of a sampling pool of 100 drivers in Los Angeles, 75 of that sample cannot be above average.
The problem with looking at our own capabilities through rose-tinted lenses is that it can lead to bad decisions—and when it comes to investing, those bad decisions can have real financial consequences.
The Wobegon Effect
“…Where all the women are strong, all the men are good looking, and all the children are above average.”
Garrison Keillor pokes fun at this particular human foible in his Lake Wobegon stories on the radio. As a result, the tendency to believe we’re above average is sometimes called the Wobegon Effect.
Why do we do it? There are several theories about our tendency to overestimate our capabilities.
For one, there is probably an evolutionary component. Human civilization would probably not have advanced very far if the majority of our ancestors had shuffled around constantly bemoaning their lack of abilities.
And part of it probably stems from a lack of evidence to tell us one way or the other. We drive to work every day and as long as we manage to get there and back in one piece as a general rule, who is to say that we are not above average drivers?
Or, when we do get evidence its real meaning is obscured. That B you received in “Behavioral Psychology 101” might mean that you are above average—a C is supposed to be average, right? But in a culture of grade inflation, it more likely means that the professor handed out a few As and a few Cs, with the vast majority falling into the middle with Bs.
Predicting the Stock Market, Or Guessing?
Predicting the stock market has a natural allure—there’s money to be made! Being known as a good stock picker can also add a nice boost to one’s social profile. T
he time-honored Cocktail Party Theory of Investing holds that a fairly important part of the satisfaction obtained from doing well in the market comes from the chance it affords to regale the neighbors with tales of your successful exploits.
In reality, though, predicting the stock market is a notoriously difficult proposition. Most professional stock fund managers don’t do a good job of it, let alone the amateur day trader.
The fact is, on any given day, all sorts of things move the market in ways that do not easily lend themselves to predictive analysis—and whatever analysis you are applying to those stock picks is likelier than not being replicated or improved on somewhere else.
The Perils of False Alpha
A tendency to overvalue one’s own stock market predicting ability may intensify with a “hot streak.” It’s important to remember that in more cases than not, the success is due more to luck than anything else. Statistically speaking, a run of good luck is likely at some point—just as there is an increasing chance of getting a run of five heads in a row, the more times one flips a coin.
In the investment world, we call this “false alpha” and even seasoned investment pros are not immune to its charms. But false alpha can lead to a tendency towards riskier decisions that are out of line with a portfolio’s long term return objectives and risk tolerance.
Impulsive decisions, stemming from overconfidence in one’s own abilities can do significant harm to the portfolio’s ability to deliver the returns over time needed for a comfortable retirement, or to meet the kids’ educational expenses.
It’s helpful to remember that Lake Wobegon doesn’t exist in real life—we can’t all be above average and we should have a healthy respect for that fact, particularly when it comes to things like predicting the stock market.
Tell us…How do you rate your ability to predict the stock market?
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