Resources/Weekly Insights

Volume 10, Edition 34 | September 27 - October 1, 2021

Avoiding Investor Pitfalls – Overconfidence

Doug Walters, CFA

Overconfidence can lead investors to believe that they can outsmart the market in unrealistic ways. Such thinking can have a devastating impact on long-term portfolio performance. An evidence-based approach can help avoid this common investor pitfall.

We close out our three-part series on Investor Pitfalls with another behavioral finance favorite, overconfidence. This single characteristic human trait is in part responsible for an investor’s tendency to market time and excessively trade, both of which can be detrimental to portfolio returns.

Do you suffer from overconfidence? Many would answer “No.” But tell me this, are you an above-average driver? In 1980 psychologist Ola Svenson found in a survey of American college students that 88% said they were in the top 50% of drivers. Other studies have found similar results. We clearly think very highly of ourselves! Experts are just as guilty. Studies of investment analysts have found that when they were 80% certain a stock was going up, they were only correct 40% of the time.

So what are the risks of this overconfidence? One is excess trading. If you are confident in your ability to outsmart the billions of market participants, you are likely to trade more. Yet trading volume is negatively correlated with returns. One study showed those prone to excess trading showed returns that were a third less than those that traded an average amount. That is a considerable performance drag.

Another risk of overconfidence is market timing. We wrote a white paper on market timing a few years back (Market Timing: Investing or Gambling?). The general message was, “don’t do it.” Not only do you have to be right on the way out, but you also have to be right on the way back in. The odds are not in your favor. Part of the reason is that most of your long-term returns accrue in a very small number of days. If you miss one of those days, the long-term impact on your portfolio could be enormous. The study we performed in the white paper was from 12/5/1996 – 5/31/2017. Over that 20+ years, missing the ten best trading days of the S&P 500 would have cut your average annual return from 7.9% to 4.3%! (of course, you would never just own the S&P 500… diversification!) So, 46% of your returns were earned on just ten of the over 5,000 trading days of that period! Yikes.

Time is your friend, impulse is your enemy. Take advantage of compound interest and don’t be captivated by the Siren song of the market.
Warren Buffet

A good, evidence-based process can combat overconfidence. Evidence-based investors do not try to predict the future, but instead, prepare for it with well-diversified portfolios and opportunistic rebalancing. A good rule of thumb in investing is that any time you find yourself saying, “I think,” hit the pause button and refocus on what you know.

Headlines This Week

US Stocks fell this week to close out the third quarter. In September, The S&P 500 was down nearly 5%. The last monthly decline we had of that magnitude was last September. Since then, stocks are up nearly 30%.

Reflation Outshines Growth

One interesting characteristic of the recent declines is that Value and other cyclical segments of the market are outperforming expensive mega-cap growth stocks.

The market dynamics are broadly in line with the “reflation” theme… i.e. economic recovery driving outperformance of the more cyclical sectors.
Some of this sentiment may be driven by declining Delta variant cases.
In addition, strong durable goods orders may have helped convince investors that demand remains strong, and the recovery will continue. Another economic datapoint closed out the week, PCE inflation – the Fed’s preferred measure. Core inflation stayed the same in August which is a promising sign that inflation may be transient.

Washington Cliff Hanger

Legislators entered the full dealing with a trifecta of priorities: funding the government to avoid a shutdown, raising the debt ceiling so the country can pay its debt obligations, and reaching a compromise on two big infrastructure spending bills.

The government funding piece is done. That was the easy one.
Raising the debt ceiling should be easy…we do not want to default on our debts. That would be a worst-case scenario for investors. It should not happen, but legislators are currently playing a high-stakes game of chicken. The deadline is mid-October, so expect the finger-pointing to continue until then.
Infrastructure is the hard one. There is general agreement on a hard infrastructure bill (bridges, roads, etc.), but the social infrastructure bill is less straightforward. For investors, this has two pieces: the stimulus that will come with a spending bill, and the potential tax implications. At the moment, details are vague on both aspects.

The Week Ahead

Eyeing Employment

ADP employment change and Nonfarm payrolls for September are out next Wednesday and Friday, respectively.

All eyes will be on next week’s jobs numbers as they remain as the key metric standing between the Fed and the beginning of tapering.
If the numbers satisfy Chairman Powell’s definition of “a reasonably good employment report,” as he put it at last month’s FOMC meeting, it would all but lock in a November taper.
Projections are for Nonfarm payrolls to come in at 500k for September, helped by ending emergency federal unemployment benefits on September 6th.
If those numbers stand up, unemployment will inch down to 5.1% from last month’s 5.2%.
Also out on Friday will be the average hourly earnings report which is expected to be slightly lower but stay in positive territory at 0.4% growth month-over-month.

Oil Outlook

The Organization of Petroleum Exporting Countries and allies (OPEC+) will meet on Monday to review their output policy.

The meeting will determine if the participating countries stick with the planned output increase of 400,000 barrels a day or opt for even more as oil prices are currently at three-year highs.
It is unlikely the group deviates from their stated plan as they might not see the market being tight enough to warrant any change in current policy.
OPEC+ intends to phase out its pandemic-era supply curb of 5.8 million barrels a day by September 2022.

Raising Rates

New Zealand is widely expected to become the second developed country to raise interest rates when its central bank meets next Wednesday.

The Reserve Bank of New Zealand (RBNZ) is expected to raise the country’s interest rate by 0.25% to 0.5%.
The move will hopefully cool off the hot economy that is seeing a surge of inflation.
Across the Tasman Sea, the Reserve bank of Australia (RBA) will also meet, but under entirely different circumstances from its neighbor.
Forecasts expect the RBA to keep rates on hold as the Australian economy struggles to gain momentum under renewed lockdowns.

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