Let me ask you a question: where does confidence come from? Does it come from experience? As in the idea that you've seen it before, so you know what's going to happen this time around? Or does it come from knowledge? Perhaps from things you've researched and studied, or facts and figures you learned in school? Or maybe it comes from intuition -- a hard-to-describe "gut feel" that you can't quite define, but you know to be true.
I've been asking myself this question over the past couple of weeks, mostly because I've been poring through various analysts and managers predictions for 2014. But also because of a very interesting roundtable I sat in on recently with a TIGER 21 Member Group from New York.
In this group, a number of members were very confident about the U.S. recovery, and what it meant for their portfolios. They noted employment was slowly adding up jobs, corporations were producing profits, and stock market performance was rising in tandem. They anticipated a strong economic performance in 2014, although perhaps a little less so in the market, if only because 2013 was so good.
But there was one member who was equally confident about how negative things were. The recovery isn't nearly as strong as it should be, real estate prices in many U.S. markets remain far below their peak, and U.S. government debt continues to grow. While he wasn't predicting an imminent economic collapse, he was keeping a substantial part of his portfolio in cash.
Personally, I tend to agree a little more with the latter opinion, due to sentiment-over confidence. We're coming up to the five-year anniversary of the financial crisis low point (March, 2009), and the S&P 500 has rallied more than 175 per cent since then (including dividends). What I remember most about that time is how profoundly negative sentiment was -- the most negative I've seen in the 26+ years I've been in the business. Most everyone (media, investors, advisors) was absolutely sure we were headed for the next Great Depression.
Interestingly, things are almost the opposite today. Looking at the most recent U.S. Investor sentiment surveys, bullish sentiment is at an all-time high and bearish sentiment at the lowest levels seen in over 20 years. Traditionally, that's been a pretty good sign that it's time to raise some cash and be hyper-vigilant with your investment due diligence. (This graph makes a convincing case).
On a deeper level, the discussion got me to thinking about confidence in a broader sense, and considering how it plays an important part in shaping investment decisions, and ultimately, investment outcomes.
Confidence is obviously a big part of the economy and the stock market. The more people who believe stock prices will rise, the more people will buy stocks -- which in turn causes stock prices to rise. The converse is also true: the more certain people feel in their pessimism, the less inclined they are to participate in the market. Either way, it's a self-fulfilling prophecy.
But is such a feeling of confidence (either positive or negative) always beneficial to investors? I would argue that it isn't.
Think about how confident people were back in 2007, prior to the 08/09 financial crisis. Many believed housing prices would always go up, the stock market would always rise, and the banks were solid, and so on. Then, after the meltdown, many people were absolutely certain that the financial dark ages were upon us, and economic disaster was imminent. In both cases, this extremely high level of confidence led to some very bad investment decisions.
In my experience, overconfidence can lead to four critical investment mistakes:
Concentrated bets
A sure sign of overconfidence is the "all in" bet: overloading the portfolio in a single security, or cashing everything out in a belief that the market is in for a fall. Both of these are highly emotional actions, and in my experience, nearly every time, such decisions turn out badly.
Binary thinking
Overconfident investors tend to believe in what I call "binary" outcomes: either the market (or a stock, or a sector, or a specific country) is going to the moon, or it's going down a hole. Now, it's true, certain forms of investing are by nature binary (biotech; mineral or resource exploration; venture capital; etc.). But unless you're a speculator, the majority of investment outcomes (both good and bad) are going to be shades of grey.
Downplaying risk (or ignoring it altogether)
The more confident people are, the more willing they are to do dangerous things. They tend to believe in "sure things," "slam dunks," and "easy money," while rationalizing away risk. I call this the "it's different this time" argument. I remember Sir John Templeton recognized these are "the four most dangerous words to an investor."
No "Plan B"
So what happens if you're wrong? Do you have a contingency plan? Overconfident investors rarely do. They sometimes fail to monitor their investments for changes, and they usually don't have an exit strategy if things go wrong.
So what's the solution? I call it "cautious confidence": temper one's optimism and one's pessimism as well.
I've noticed this is a trait many successful high-net-worth investors share. They are generally "glass half full" people (particularly about the long term), but they are humble as well. Most of them have made mistakes, and have had to overcome them on the road to greater success.
So go ahead, be confident. But be cautious about it, and protect yourself by doing your homework and being open to the possibility that you may be wrong. Above all, remember: it's not what you know that gets you in trouble—it's what you know for sure.
Thane Stenner is founder of Stenner Investment Partners within Richardson GMP Ltd., as well as Portfolio Manager and Director, Wealth Management. Thane is also Managing Director for TIGER 21 Canada (www.tiger21.com/canada). He is the bestselling author of ´True Wealth: an expert guide for high-net-worth individuals (and their advisors)'. (www.stennerinvestmentpartners.com) (Thane.Stenner@RichardsonGMP.com). The opinions expressed in this article are the opinions of the author and readers should not assume they reflect the opinions or recommendations of Richardson GMP Ltd. or its affiliates. Richardson GMP Limited, Member Canadian Investor Protection Fund.