The Seven Deadly Sins of investing

David Allen (0:13)

Thank you very much for having me here today. We're going to do a few polls today. So, if you've got the QR code just to make those work, be fantastic if as many of you could do those now. It's very, very quick. It's all anonymous. We're not going to throw anyone's names up there in lights, but just to make the presentation work, that'd be fantastic just to take 30 seconds to do those. Just while you're doing that, I'll give a quick introduction. So, as I said, I'm going to talk about the seven deadly sins. Unfortunately, these aren't the exciting, the fun deadly sins. There's no gluttony. There's no lust, not even any sloth. Instead, we're going to talk about the seven ways our brains systematically conspire to make us worse investors. And I should say at the outset, this certainly isn't a lecture about the sins other people commit in investing. I myself have been investing for 25 years and continue to make these sins each and every day. The problem really is that just knowing these sins, these behavioral biases doesn't make you immune to them. So rather than trying to become perfectly rational investors, which I think frankly is impossible, I'm going to conclude today by talking about how you can design an investment process that protects you from your worst enemy yourself.

So the first quiz was, do you believe you're a better investor than 50 percent of the people in this audience? Can we have the results, please?

There you go. So that's interesting. So only 27 percent of us said that we are better investors than the average and changing. That's got to be the first investment conference in history where that result has taken place. Your client should redeem their money right now, I think.

Okay, we'll move to the next question.

Do you believe you're a better lover than 50 percent of the people in the audience?

Oh, wow, your marriages are in real trouble.

So the normal results that you get in these results is almost universally that people are overconfident. In fact, in the cognitive psychology literature, the most pervasive, most ubiquitous flaw that they find is overconfidence. So, if we just go back to the presentation, please. For example, 93% of people believe that they're better drivers than the median. 94% of university professors believe that they're better than the median. In a classical brokerage study, men trade 45% more than women, and significantly underperform women largely due to trading costs. Okay. So, I think the next time for the men in this room, some advice that you're struggling with an investment decision, probably best thing to do is ask your wife what to do.

So, investing really, from an evolutionary perspective, if we weren't overconfident, if we really knew the true odds of success and survival, we probably wouldn't have the energy or the will to get up in the morning. So, overconfidence is really a coping mechanism in many ways, and investing is almost perfectly designed to create overconfidence. Markets are noisy. The market goes up, we attribute it to our own skill and genius. The market goes down, oh, well, that's just bad luck. That's just short-term noise. Way back in early 2009, I was at JP Morgan. That was the height of the financial crisis. Markets were crashing. Financials that we were short were down 90%. We made a fortune shorting these names. Then suddenly, the market turns on a dime. It's up 150% for these financial positions we were short in a couple of months. And we'd become overconfident. We'd become complacent. So we actually have it hardwired into our investment process at Plato to ensure that whenever a stock is 80% off its stock price peak, it gets automatically closed. Sure, it could go bankrupt, but the risk is asymmetric. A little bit of good news could send that stock heavily northward. So there's another form of overconfidence that I think is even more important in terms of investing. And that is calibration or lack thereof. Statistically, when people say that they're 90% confident something is correct, they're actually only right 75% to 80% of the time. When they say they're 100% certain, they're actually right only 85% to 90% of the time. Which brings us to one of the great philosophers of all time, the great Ron Burgundy of Anchorman, who says 60% of the time it works every time. So probability doesn't necessarily come particularly naturally to us.

The second sin I'd like to talk about is the hot hand fallacy. This idea is we're seeing persistence and randomness, as Todd was alluding to before. The idea originally came from basketball, where they did a study and what they found is, when we're all watching a game, a player makes three or four shots in a row and we think, oh, they're on fire, get them the ball, they can't miss. But when they actually studied this statistically, they found that even if you've made a run of shots, your chance of having a successful next shot is only ever so slightly higher than your base rate. But we're hardwired to see patterns when none actually exist. We're designed, I think, from evolution to be pattern recognition machines. That was really useful when the pattern was every time I walked past that cave, something tries to eat me, but is less valuable when you're staring at a Bloomberg screen, because we don't just see patterns where they exist, we see them everywhere.