(PHOTO: Source, www.michaelmauboussin.com)
One of the great things about being a stock market investor in the year 2016, is that we have the internet. That means we have access to loads of free information to help us become better investors.
There’s lots of great research that tells us why we continue to underachieve in the stock market. One of my favorite bits of research is by a guy called, Michael Mauboussin.
Michael Mauboussin is the Managing Director and Head of Global Financial Strategies at Credit Suisse. He’s also written three books, he’s been an adjunct professor of finance at Columbia Business School since 1993, and received the Dean’s Award for Teaching Excellence in 2009.
So, it’s fair to say, he’s an expert in the area of investing!
Michael Mauboussin wrote an excellent research paper together with Dan Callahan, CFA that shows that we have an over inflated opinion of how well we make decisions, including those related to stock market investing.
The paper, titled IQ versus RQ – Differentiating Smarts from Decision-Making Skills. Think of IQ as the horsepower of an engine and RQ as the output. The research demonstrates that we think we’re smarter than we actually are.
When asked about his success, Warren Buffett emphasized that it was RQ that made the big difference, not IQ.
How I got here is pretty simple in my case. It’s not IQ, I’m sure you’ll be glad to hear. The big thing is rationality. I always look at IQ and talent as representing the horsepower of the motor, but that the output—the efficiency with which that motor works—depends on rationality. A lot of people start out with 400-horsepower motors but only get a hundred horsepower of output. It’s way better to have a 200-horsepower motor and get it all into output.
One way to assess our rationality is through a test of calibration. Think of a weather forecaster. If it actually rains 70 percent of the time on the days she predicts a 70 percent chance of rain, she is well calibrated. She is poorly calibrated, on the other hand, if it only rains on 30 percent of those days.
Mauboussin and Callahan conducted this classic calibration test, which you can take too, with 1,985 participants. The test requires that you answer a series of questions, then state how confident you are that your answer is correct. That is, if you are unsure whether your answer is correct you would select 50% confident. If you are certain that your answer is correct, you would select 100%, and anywhere in between.
Here’s what they found:
The horizontal axis (the one at the bottom) shows how confident the participants were with their answers. The vertical axis (the one on the side) shows whether the participants answers were in fact correct.
When the subjects selected 50 percent, their probability of being correct was random. This means they were well calibrated. They didn’t know, knew they didn’t know, and answered as if they didn’t know.
However, as the assigned probability of correctness rose, the subjects became less calibrated. For instance, when the subjects selected 100 percent, they were only correct 77 percent of the time. At 90 percent, they were only correct 65 percent of the time. Overestimation of ability was greatest at the high levels of assigned probability of correctness.
So why is this important to us as investors?
The research provides the following answers:
“Overconfidence can be a problem for a couple of reasons. The first obvious one is if you are highly confident of an outcome and are wrong a relatively high percentage of the time, you will fail to consider alternatives and ultimately make poor decisions”.
“Another problem is that people who think that they know more than they do are less motivated to learn and improve than those who understand their limitations.”
Neither of these answers are going to make us successful stock market investors!
Another answer, as to why we have over inflated opinion of how well we make decisions, is provided by David Brooks in his book, The Social Animal:
“Worse yet, the most powerful among us have a tendency to bloviating [talk at length, especially in an inflated or empty way] certainty — swatting away doubt and choosing up sides precisely because not having answers feels so uncomfortable and potentially threatening.”
As an investor, its important to be humble and know that there’s a lot you don’t know, even if you think you do!
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