March 5, 2015
We Can’t All Be Above Average!
The four most expensive words in the English language are "this time it’s different."
-Sir John Templeton
While many experienced investors and advisors may not be familiar with the origin of this expression, they’ve undoubtedly heard it uttered and nodded strongly in agreement. Why then, through their investing recommendations and actions, do those same experienced investors seem to subconsciously think "but I am different". Perhaps those are the next four most expensive words!
It’s a common belief that the inexperienced, unsophisticated retail investor typically falls prey to the "this time it’s different" proclamations. There is certainly plenty of evidence to support the belief, but is it only those retail investors that succumb to this trap and the group think mentality that typically accompanies it? As an investment professional who has lived through the dot-com bubble, the housing bubble, and the ensuing financial crisis it is hard to ignore the evidence that both experienced and inexperienced investors alike are equally vulnerable. The quote below from Warren Buffett goes even further by comparing Wall Street to lemmings (with the lemmings coming out convincingly ahead!).
"A group of lemmings looks like a pack of individualists compared with Wall Street when it gets a concept in its teeth."
Undoubtedly many will argue that the quote from Warren Buffett is simply a testament to Wall Street’s desire to sell whatever product is trendy or hot. Having spent a good portion of my early career with Wall Street firms, I’d argue that is only part of the equation. I’ve witnessed firsthand the construction of and marketing of these "hot products" and know that their developers actually did believe in them. In some cases they recognized many of the very risks that led to the product or strategies downfall, but they remained steadfast in their belief that they were uniquely equipped to navigate through any issues.
As a student of behavioral finance I’d argue that a portion of that last sentence holds an important clue as to why Wall Street is repeatedly susceptible to ignoring such a commonly accepted concept and belief. It’s the idea that they and they alone are "uniquely" equipped to handle whatever comes their way. It may not be different this time, but they are somehow different than everyone else. A psychologist would recognize this as illusory superiority and control. I’m sure I don’t need to convince anyone that Wall Streeter’s think rather highly of themselves, but the illusion of superiority and control is not at all unique to Wall Street or even investing broadly. They do, however, provide some convincing concepts for understanding what happens in that world and why economic, market, and product boom and bust cycles are destined to continue repeating.
Illusory superiority is a bias that causes people to overestimate their positive qualities and abilities and to underestimate their negative qualities, relative to others. It’s sometimes referred to as the "above average effect". Illusory superiority has been observed and researched in a wide variety of areas, including academic, social, and work environments. Perhaps the mostly widely cited studies relate to ones driving ability. Several studies have been performed, with strikingly similar results. One of the first was a study done in 1981 of 161 students in Sweden and the US asking them to compare their driving skills and safety to the other people in the experiment. For driving skill, 93% of the US sample and 69% of the Swedish sample put themselves in the top 50%. For safety, 88% of the US group and 77% of the Swedish sample put themselves in the top 50%.
A few other studies that were interesting and quite telling:
- In a survey of faculty at the University of Nebraska, 68% rated themselves in the top 25% for teaching ability.
- In a survey of MBA students at Stanford University, 87% rated their academic performance as above the median.
- In a survey attached to the SAT exams in 1976, 70% of students put themselves above the median in leadership. In getting along with others 85% believed they were above the median and 25% even put themselves in the top 1%!!!
The illusion of control is the tendency for people to overestimate their ability to control events and outcomes they demonstrably do not have any influence over. This is the one that the folks in Vegas hope we never find a solution for! Every person sitting at a slot machine in Vegas, somehow is convinced that if they personally pull the lever or push the button that their odds magically improve.
Ellen Langer, a Harvard psychology professor and author, was the first to demonstrate the illusion of control through her research. In one of her experiments, since replicated by other researchers, subjects were either given random lottery tickets or allowed to choose their own. They were then given the opportunity to trade those tickets for others that had a higher chance of winning. Subjects who had physically picked their own tickets or had tickets bearing familiar symbols were less likely to exchange their tickets despite the increased odds through an exchange.
There are countless more fascinating research results on the topic. Here are a few more that I found interesting.
- In one study, early "success" in a random event (like a coin toss) led to overestimating the total number of wins during the session and having a higher expectation for success in future events. This particular study was actually rigged by the researcher so that those with early success had the exact same end results or number of successes as other participants.
- Participants in random events consistently demonstrate a higher degree of confidence when they are allowed to practice an event (even a totally random one) or are allowed to make their guess before the event happens (like a roll of the dice at the craps table).
- Speaking of playing Craps – when rolling dice in a craps game people tend to throw harder when they need high numbers and softer for low numbers.
It doesn’t help that most illusion of control studies also found that the illusion is greater in stressful and competitive situations. Sounds a bit like the perfect trap for traders and investors!
The implications of illusions of superiority and control are often harmless and even amusing in certain settings. Their impact on investment results, however, as Sir John Templeton was so aptly quoted can be very "expensive". An investment plan or philosophy that doesn’t attempt to account for and remove these basic human tendencies will inevitably succumb to them. After all we can’t all be above average!
While educational, my experience as a trader and advisor with several Wall Street banks instilled in me a strong desire to help the clients I worked with avoid these repetitive and expensive behavioral traps. That aspiration led me on a search for a better model, a model I’m convinced I found when I joined Hirtle Callaghan.
Brad Swinsburg, CFA, CAIA
Brad is a Vice President on the Portfolio Management Team with Hirtle Callaghan and has more than a decade of experience working with affluent families. Prior to joining Hirtle Callaghan he spent ten years with Goldman Sachs in South Florida where he served as a Vice President and partner on the firms’ largest wealth management team in the region. More recently he spent two years with the Atlanta office of the J.P. Morgan Private Bank as a Global Investment Specialist. Brad is a senior member of the Portfolio Management Team and works with many of the firms’ largest family clients where he works on structure, implementation, and oversight of investment programs. Brad received his B.S. in Business Administration from Susquehanna University where he was also a member of the varsity basketball team. Brad is a CFA and CAIA charter holder and a member of the CFA Institute and CFA Society of Atlanta.