Last Week Today. On June 29th President Trump and Chinese President Xi Jinping agreed to reinitiate trade negotiations – an outcome hoped for by the market, but evidently not fully priced as the S&P 500 reached a new record level last week. | The European Parliament nominated France’s former finance minister and current managing director of the International Monetary Fund, Christine Lagarde, to replace Mario Draghi as the first female President of the European Central Bank. | President Trump announced two nominees for empty seats on the Fed’s board of governors. Christopher Waller is a research director at the St. Louis Fed and former mentor to current St. Louis Fed President James Bullard. Judy Shelton has the academic qualifications to make the cut, but controversially she is an outspoken critic of the institution. Both nominees appear to advance the President’s desire for a more accommodative Federal Reserve. | June’s nonfarm payroll report (released Friday) was stronger than anticipated, reducing the impetus for the Fed to cut interest rates proactively.
Risk Rewarded. Global equities pushed higher in a U.S. holiday-shortened week. Domestic stocks led the way once again, as the S&P 500 gained +1.7%. International developed markets rose by +0.5%, and emerging market equities gained +0.7%. At approximately the halfway mark, it has been an excellent year for equity investments: S&P 500 +20.6%, International developed markets +15.1%, and emerging markets +11.5%. Taking a closer look at sector performance within the S&P 500, Information Technology has been shining in 2019, but even Healthcare, the worst-performing sector, is up nearly double digits.
Sources: Bloomberg LP and Covenant Investment Research
The question on everyone’s mind is “Can this continue?” The answer is that it most likely can in the intermediate term, but not at the same pace and with more volatility than witnessed thus far. With the usual caveat that this outlook excludes the potential for exogenous events like natural disasters (you hear me California?) or geopolitical risks, it also assumes the Federal Reserve does not commit a monetary policy mistake, and that trade tensions remain at a low simmer rather than a rolling boil. One reason is that the economy remains relatively stable. Yes, the global economy is slowing and the domestic economy is retreating from the unsustainable pace of 2018, but so long as consumer confidence remains high and they continue to spend, our “Good but not Great” growth scenario can stay intact. Current data shows domestic GDP growth slowing materially in the second quarter (among other things, the build-up in inventories from Q1 needs to be worked off), but a return to the post-Financial Crisis 2% average growth rate is reasonable. The second important factor supporting equities is the return of “TINA.” With the yield on domestic bonds pushing lower to levels last seen in 2015/2016 and more than $13 trillion of bonds with a negative yield globally, for many investors There Is No Alternative to equities.
How the Mind Works Against Successful Investing – Overconfidence
(Entry #3 in a series on Behavioral Finance)
The next Emotional Bias we explore is “Overconfidence.” Psychological research has convincingly demonstrated that humans tend to have an inflated view of their decision-making abilities. As such, this human frailty affects nearly all aspects of our lives. Famously, when people are asked to rate their driving ability compared to other drivers, most rank themselves in the top third of the population. Obviously, this is mathematically impossible, as 50% of all drivers’ abilities are at or below average.
Overconfidence’s successful twin “confidence” can be described as a belief in one’s self and one’s ability to succeed. This type of positive thinking has been critical to the evolution of the human race. For example, if our ancestors were not confident in the future, there would have been no incentive to take risks or to defer gratification. But too much confidence can blind you to otherwise obvious obstacles.
Striking a balance between confidence and overconfidence is challenging, and there is often only a thin, red line separating the two. In finance, Overconfidence is an extremely dangerous bias as actions taken from an overly confident mindset may be the most harmful to your wealth.
In simple terms, investors commonly believe they are more intelligent and have access to better information than they actually do. As a result, investors tend to be overly optimistic about their estimates and attribute successful decisions to their skill and poor outcomes to bad luck. Overconfidence destroys wealth through the following emotionally-charged, risk-seeking, investment errors:
- Mistaken belief in one’s own ability to outsmart the market
- Excessive Trading
- Underestimating downside risks
- Concentrated portfolios
Often investors commit two or more of these errors simultaneously. To illustrate this point, let’s review the average investor’s experience with Fidelity’s wildly successful Magellan Fund. Peter Lynch earned a reputation as a legendary portfolio manager racking up a 29% annualized return (10% better than the market) when he was responsible for managing the fund from 1977 through mid-1990. The fund was not available to the public until 1981, but even from that point forward, Lynch generated an annualized performance of approximately 23% through 1990 vs. 16.5% for the S&P 500. However, according to Fidelity’s calculations, the average investor in the Magellan Fund only earned around 7% per year.
The paltry performance of the average investor was not Fidelity’s fault, but rather because the average investor repeatedly committed the first two errors listed above. When the fund would experience an inevitable setback, investors would redeem from the fund. Then, when performance improved, investors would rush back into the fund, missing a big part of the recovery. Overconfident bets about the future direction of the market and the associated trading provoked the average investor to buy high and sell low over and over again. As a result, those investors not only missed out on Magellan’s market-beating performance, but they also earned less than 50% of the broader market’s gains. Ouch!
Investors suffering from the Overconfidence bias may also underestimate investment risks and/or concentrate their portfolios in a few investments. Together or independently, the market often teaches investors committing these mistakes an expensive lesson. For example, during the Dot.com bubble, those investors that did not trim their winners or diversify their portfolio into non-technology stocks, suffered catastrophic losses when the bubble popped, and the Nasdaq Index declined by 78% from March 2000 – October 2002.
How to address the Overconfidence bias:
- Consider downside scenarios and assign a probability, or likelihood, that those scenarios come to fruition.
- Maintain a properly diversified portfolio, based not on the number of investments in the portfolio, but the types of return drivers for those positions.
- Recognize that both good results and bad results typically come from decisions you made previously. Most people attribute good results to their competence and poor outcomes to bad luck. There’s no doubt luck plays a role in investing, but it balances out over time, whereas your decisions are a constant input to the outcome.
- More information does not necessarily make for a better decision. Research studies show that investors are more confident in their forecasts when they have more information, but the reality is their forecasting accuracy was little changed regardless of the amount of information provided. Typically, a successful forecast hinges on only a handful of data points, therefore do not confuse quantity with quality of information you are evaluating.