On this week’s show, Karl discusses how overconfidence in trading can hurt results and impact financial plans. Plus, the week that wasn’t.
Karl Eggerss: Hey, good morning everybody. Welcome to the podcast. It’s Creating Richer Lives. Thanks for joining me as always. Our telephone number, (210) 526-0057. Our website, creatingricherlives.com. And don’t forget, this podcast is brought to you by Covenant Lifestyle, Legacy, Philanthropy. And at Covenant, our goal is to unburden clients from the daily cares of financial management. Again, creatingricherlives.com. If you’re not getting our information, our podcast, any of those things, if you’re listening and this is your first time and you stumbled upon it, all you have to do is go to our website and you can sign up to get that information. And we just launched, last week was the first week we did it. We just launched Covenant You.
Karl Eggerss: We’re calling it Covenant You, because we’re really trying to give you the latest information and educate you to help you with your finances. So therefore, what we’ve done is each and every week, Monday afternoons, you will receive an email from us with anything we’ve posted on our site, anything we want to communicate to you, and it’s in one email. You can choose how you want to watch it, listen to it, read it, totally up to you. We know some people like to read things, some people like to watch things, and we are putting a lot of information out there to help you, and we have it in one distribution now for you. So if you want to sign up for Covenant You just go to creatingricherlives.com and you can do that.
Karl Eggerss: All right, in just a little bit, we will be having a guest in the studio. We had Justin Pawl Covenant’s chief investment officer in here last week. I’ve invited him back to cover another investment bias or mistake that he sees people making when it comes to their investments. So we’re going to go over that in just a minute, but before we do, let’s go over the markets here. We had, really, a boring week, so we’re not going to spend a lot of time talking about the markets this week, because it was kind of quiet. I mean, the biggest news obviously was this impeachment stuff going on, which didn’t relate to the market, and it shouldn’t have, and it didn’t. So what we have right now is the market was, on balance, down a little bit, but a pretty boring week.
Karl Eggerss: We’re in that part of the year where stocks seasonality will tend to kind of meander, and we’re certainly doing that. We’re not very far off of all time highs of course, but it’s almost as if we can’t bust through the new highs. What are we waiting for? Is it the next earning cycle? Is it a trade deal? We don’t know, but we do know we’re not off the highs very much, and we don’t want to force the action. When there’s nothing to do, don’t do it. This is how people make mistakes. Be patient and wait, and that’s what we’re doing. We’re in a situation where we obviously have a Fed that differs on interest rate policy. Some believe rate should be risen, some believe there should be more cuts, some believe they should do nothing.
Karl Eggerss: We have a very bifurcated Federal Reserve Open Market Committee, and we’re still waiting on a trade deal. I mentioned this the last couple of weeks, there seems to be less movement in the markets when there’s positive news, it’s kind of wearing off. Used to be, “Hey, there are talks scheduled for a month from now, and the market would jump up two, three hundred points. Now, we see talks are scheduled to resume October 10th or whatever the date, and we don’t see a big jump in the markets like we used to, and it’s because people are in a show me state, right? We’ve seen this before, we’ve heard this before. It’s as if you’re watching a ping pong match and you’re like, “Oh, she’s going to win. No, no, he’s going to win. No, she’s definitely going to win.” This back and forth when there’s nothing really happening.
Karl Eggerss: We’re having a little bit of progress I guess, but it’s not big enough to get anybody to really get excited about, “I need to buy stocks, because a trade deal is going to get done.” We’re not seeing that. So that is something that we’ll see as the weeks progress here if there’s real progress made and how the markets react to that. But we’re kind of in the doldrums of what was summer now turning into fall, but there’s nothing to do. It’s a pretty boring week overall. Usually there’s a lot of activity, and we did have some positive economic news, but nothing to write home about. So again, be patient and let’s realize that we have news coming to us every two minutes.
Karl Eggerss: If you have the new iPhone 11 Pro Max, which sounds like a medical drug, but if you have the Pro Max, you obviously get things dinging and chiming and buzzing and vibrating every two minutes, because there’s news coming your way, and that news makes you want to do something, but there’s really nothing to do. And so in this day and age, it’s really easy to get that information and say, “I’ve got to act on that. There’s a potential impeachment. There’s this, there’s that.” And what really affects the stock market over the longterm? It’s profits of companies. What affects bonds? Interest rates, right? There’s inflation, there’s growth.
Karl Eggerss: That’s what’s going to drive the stock market over the longterm. It’s not these little news bites, it’s not tweets. That will call some vibration, but it’s not going to move the needle over the longterm. So just stay focused. There’s not a lot to do right now. We always encourage looking over a portfolio, making sure you own the things that make the most sense, regardless of maybe where you bought them. Don’t make that mistake of, “Well, I have to get up to a certain level just to get even.” That’s not a good path to go on. You need to look at each investment. Is it still a good deal of where you would own it today? And that’s why we’re spending some time talking to Justin Pawl last week and coming up here in a few minutes about some of the mistakes he sees people making, because we’re trying to help you look at it from a different angle so that you don’t make those mistakes.
Karl Eggerss: As mentioned at the top of the show, we do have a guest today. His name is Justin Pawl. He is the chief investment officer at Covenant. Justin, you came in last week to discuss this whole, really, it’s a series we’re trying to do on some of the mistakes people make that are really up in their head, right? They’re psychological, mental mistakes, behavioral finance, behavioral economics, it’s got a lot of different terms. Last week, I wanted you to cover a couple of them. It turned out we covered one because it’s such a fascinating topic, each one of them and why these things happen. So last week, we talked about loss aversion, and you had the example of a coin toss and ran through some of the statistical evidence of what people choose versus maybe what they should be choosing.
Karl Eggerss: What is another mistake that you see investors make when it comes to looking at their investments or acting on their investments?
Justin Pawl: Yeah, this one’s actually-
Karl Eggerss: By the way, welcome back.
Justin Pawl: Yeah. By the way, I forgot to thank you for having me back again, Karl. It’s a pleasure, again, to be here. So this morning I thought we’d talk about overconfidence. Overconfidence is something that is prevalent throughout human beings. We’re all confident in certain skills and certain decisions that we make, and that’s fine, but it’s when that confidence turns into overconfidence that investment decisions or investment errors occur. So if you think about it from a group setting, I’m sure you’ve been in these situations where you’ll be in a large auditorium and the person who’s speaking will say, “Raise your hand if you think you’re better than the average driver?” Well, how many people raise their hand? Nearly everybody raises their hand, right?
Karl Eggerss: Right.
Justin Pawl: Well, statistically you know 50% of those people can only be better than the other drivers in the room. So that’s an idea that people have this inflated view of their decision making capabilities, of their skillsets, and it’s this overconfidence that causes problems to occur in all facets of decision making, but specifically when it comes to investments. Now, taking a step back, I mean, confidence is important. Confidence is what allowed societies to develop. If people way back when weren’t confident in the future, they wouldn’t have stored food for future consumption, they would’ve consumed it all right then, right?
Karl Eggerss: Yeah.
Justin Pawl: So confidence is an important facet of being a human being, but it’s that thin red line where you cross from confidence into overconfidence that the problems start.
Karl Eggerss: It’s interesting, when it comes to investments though, it seems like, at least some people that I’ve met, they don’t know they’re being overconfident. Does that make sense?
Justin Pawl: It does.
Karl Eggerss: In other words, let’s just say somebody comes in and they have 75% of their net worth in one stock, a lot of those people literally don’t know the risks they’re taking, so I wouldn’t necessarily categorize that as overconfidence. And maybe that’s another behavioral issue we’ll talk about another time. But you understand what I’m saying? That’s not overconfidence, that’s just a lack of really understanding the risks they’re taking.
Justin Pawl: Well, I think it actually does have roots in overconfidence, Karl. And the reason is that they, for whatever reason, believe that they have better information than the market does about that particular stock, and they therefore believe that that stock price is not currently reflect the intrinsic value of that stock, so that over time they expect to make a lot of money off that particular position.
Karl Eggerss: And when do we see that particular situation? It’s either, “I work at the company, so therefore I see that we’re doing really well,” which they don’t. They don’t really know what higher up management may be about to do or not do, or it’s an inheritance, “I just can’t let the stock go because my grandfather told me never to sell it.” Usually when you see that concentrated position. But again, I don’t want to get off track from overconfidence. So give me some other examples. I mean, obviously, again, a concentrated position is overconfidence.
Justin Pawl: Well, let’s talk about a real life example. You’ve probably heard of Peter Lynch, he was the famous portfolio manager for Fidelity’s Magellan Fund, and he did that from 1977 through 1990. And over that timeframe, his fund, the Magellan Fund, appreciated by an average of 29% per year, remarkable returns. Now, the underlying stock market did well also. It appreciated by about 20% per year or 19%, so he basically outperformed on an annualized pace of 10% for an extended period of time. But if Fidelity-
Karl Eggerss: Which puts you in the Hall of Fame.
Justin Pawl: Absolutely.
Karl Eggerss: Mike drop, he’s a Hall of Famer.
Justin Pawl: He’s done. I mean, absolutely-
Karl Eggerss: He literally was done, because I haven’t heard from him since.
Justin Pawl: No. I mean, he retired at the peak of his game, and all the accolades, he deserves. He did really, really well.
Karl Eggerss: Yeah, absolutely.
Justin Pawl: Unfortunately, the average investor in that fund only earned about 7% over that timeframe.
Karl Eggerss: So that would tell you that they did not stay in it the whole time.
Justin Pawl: That’s exactly right. The average investor only earned 7%, because they would sell at the bottom after the stock had gone down, or they would buy at the top after the stock had appreciated. So there’s a lot of behavioral-
Karl Eggerss: The mutual fund in this case.
Justin Pawl: The mutual fund, yeah, I’m sorry.
Karl Eggerss: That’s okay.
Justin Pawl: The mutual fund in this case. And so there’s a lot of behavioral finance errors that were made in that process, but from an overconfidence standpoint, people became overly confident in their ability to predict which way the mutual fund was going to continue to go. And so when it would start to go down, they would think, “Hey, this thing’s going to keep going down, and so I’m going to sell out here and preserve the gains that I have.” Likewise, after it ran up for awhile, they would then jump on board and buy the fund, and think that it was going to continue to move ahead.
Karl Eggerss: Well, and that’s really what happened in 2008. When you start to see your portfolio drop because you have a lot of stocks, and it’s dropping and dropping like it did in ’08, the natural inclination is to look at that and extrapolate and say, “It’s going to zero.” And it did feel that way. It feels like it’s going … I mean, every day, the market’s done another 1%, 2%. And so people make dramatic moves as opposed to saying, “wait a second, I’m getting a discount. I’m getting this thing 20 or 30% cheaper.” This is the only industry I know that people want to pay a premium for something willingly, knowing they’re paying a premium, because everybody else is paying a premium versus, “Hey, something’s on sale, go buy it.”
Karl Eggerss: It’s the only industry I know that that happens in. It doesn’t happen at the malls.
Justin Pawl: That’s a great observation.
Karl Eggerss: Can I even say malls nowadays? Are malls a things still?
Justin Pawl: Maybe for some of the teenagers out there. There’s not a lot left though.
Karl Eggerss: Well the teenagers certainly don’t know what a mall is, they don’t call it a mall.
Justin Pawl: Fair enough.
Karl Eggerss: I don’t know what to call it nowadays, Justin and I are roughly the same age. But it is like that. You’re not watching a particular watch for example, and you’re watching the price of it and it’s $100, all of a sudden it goes to 60, you don’t go, “I don’t want that anymore. In fact, I need to get rid of all my watches.” No, you say, “This is an awesome deal, I want to go buy it. Stock market, not so much. And ’08 was an example of that. So I think there’s this kind of extrapolating, looking at the lines, and that’s what was happening with Magellan.
Justin Pawl: That’s right Karl. So when you think about overconfidence and what it translates into in an investment standpoint, people have a mistaken belief in their own ability to outsmart the market, to outguess the direction of the market. That leads to excessive trading. It leads to underestimating the downside risks in their portfolio, and it leads, as we talked at the outset here, to overly concentrated portfolio positions.
Karl Eggerss: Yeah. And I talk about that a lot on this podcast. I think what’s underrated is really portfolio construction, “Oh, why do I own this particular position and how much I own?” You need to be looking at how much that is relative to what else is in the portfolio, because how do they interact with each other?
Justin Pawl: That’s right. If you think of portfolio construction the way a conductor manages a symphony, you have your woodwinds, you have your horns, you have your percussion instruments. The conductor isn’t going to compose a complete song or a melody out of just percussion instruments or just the horn section. He’s going to expertly blend those together to create harmonious sound. The same idea translates into portfolio construction, where you’re trying not to overweight any individual risk in the portfolio, but rather to blend those risks to deliver the returns that someone’s looking for.
Karl Eggerss: So is overconfidence just about a lack of diversification?
Justin Pawl: No, not always. It can certainly lead to overtrading, because you’re constantly thinking that you have better information than the market, yesterday, the market went down a little bit, so today you think it’s going to go down more, so it leads you to sell your positions in your portfolio or some portion of it, and then oh, the market goes back the other way and you say, “Oh, wait, I was wrong, but now the market’s going up. I better not miss out on this, so I’m going to go ahead and I’m going to load up on stocks again.”
Karl Eggerss: Yeah. And really, I mean again, we’re not advocating for the rotisserie chicken machine, the set it and forget it.
Justin Pawl: No.
Karl Eggerss: We’re not advocating that, what we’re advocating for is making strategic allocation changes over time based on certain parameters. You and I have been talking off mic, the last few weeks I’ve been talking on mic about this whole growth versus value for example. That doesn’t mean you completely abandon every growth stock you own, because it could keep going that way for a while. All it means is you shift maybe and take advantage of the fact that value stocks are cheaper and have underperformed, then you weight a little more towards that within your equity allocation. But oftentimes, when people hear stuff like that, like growths underperformed or values underperformed, they take big, big moves. It could be well, growths outperform and I’m going to continue to do that. Some people may hear, “Oh, are you saying to sell all my growth stocks and go buy value?” And that’s absolutely not the case. We’re talking about strategic moves within a diversified portfolio.
Justin Pawl: Yeah. I think a good way to think about it is a tilt in a portfolio rather than wholesale shifts in a portfolio. To think about changing your portfolio in an evolutionary fashion as opposed to a revolutionary fashion, so that you’re not whipsawed, because yes, for a handful of days, value outperformed growth after 10 years of under-performance by value. Now, in recent days, we’ve seen that kind of flip around again already where growth outperformed value again. So trying to catch each whipsaw or each wiggle in the marketplace, that’s a losing proposition that leads to overtrading, leads to second guessing yourself and then making decisions that compound prior poor decisions.
Karl Eggerss: Yeah. So to kind of put a bow on it, how do people overcome this overconfidence? I mean, first you need to recognize it, right? So what’s the first thing to do to make sure that you’re not somebody listening saying, “Oh wait, that’s me.”?
Justin Pawl: Yeah. I think part of it begins with taking a humble pill. You need to-
Karl Eggerss: Where do they sell those? Out on CVS?
Justin Pawl: You need to have a humility about you that you’re not always going to be right in the marketplace, and that in spite of your strong convictions that aren’t based on true fundamentals, and even if they are based on fundamentals, I should say that the market sometimes takes it out of your hands. There are stocks that can look tremendously undervalued and just get cheaper and cheaper and cheaper. You need to recognize that sometimes you have to acquiesce to the views of the marketplace and cut those losers before you hold on and it goes to zero essentially, or you take on catastrophic losses of some percentage point.
Karl Eggerss: Yeah. And there are stocks that go up and you can’t really explain it, and then maybe five years down the road you look back and say, “Oh, now I see what it was.” Maybe somebody else saw that at the time, they just caught it before you did. Be transparent about that and understand. And I think, doesn’t it go back to really creating that financial plan and trying to figure out, what are you trying to do first?
Justin Pawl: It does.
Karl Eggerss: And then building a diversified portfolio. And again, some of this stuff sounds cliche, but there’s no way around it, there just isn’t. Now, are there people that have made a lot of money by being overconfident? Yeah. There’s people that have most of their net worth in their own personal business that they are confident in, maybe even overconfident, and they have made millions of dollars. That does happen. For most of the people listening, overconfidence can be a killer at times.
Justin Pawl: Absolutely. On your point about financial plans, if you’re on the golf course, the saying is, if you don’t have a target, you’ll hit it, right?
Karl Eggerss: Yeah.
Justin Pawl: So if you don’t have a financial plan, you don’t know what you’re aiming for. You’re basically just striking out in different directions that aren’t necessarily going to serve your longterm interests. And so that’s why the financial plan combined with sound investment management are such a powerful combination.
Karl Eggerss: Yeah, absolutely. In fact, when I sit down with folks most of the time, and I’m looking at a portfolio they may already have, it’s interesting because as I question, not to be hostile, but when I question like, “How did this portfolio come to be?” There’s usually not a real good answer, it’s like, “Well, I watched a bald guy on TV that throws stuffed animals at the screen and he said this was good.” And, “I listened to a guy on the radio that said to cut out my credit card, so I did that.” It’s kind of in piecemeal as opposed to being intentional about it and thoughtful about it and saying, “Okay, let me work backwards. Let me figure out, what am I trying to do?”
Karl Eggerss: Work backwards to say, “Okay, I know I need to own this much in the stock market for the longterm. Okay, what type of stocks? ETFs, mutual funds, individual stocks?” And then you’re building a portfolio. But to have 17% of your portfolio in one stock just because you got it from an uncle, that’s not your plan. That has nothing to do with your plan.
Justin Pawl: I think that’s called hope. Hope it goes up.
Karl Eggerss: It is hope. Yeah, it does. Justin, appreciate it. We’re going to have you back soon to talk about more of these, because these are probably, to me, the most important thing is how we think about our money and how intentional we are about it, because again, if you’re going to create a richer life for yourself, it starts by avoiding some of these biases and behavioral problems that a lot of people are doing every day.
Justin Pawl: That’s right. So basically, through this process of sharing this information about these biases, we’re trying to create a community of better decision makers. Obviously, in our lives it’s around financial decisions, but being a better decision maker is important throughout the other aspects of your life as well. And so hopefully by bringing this information to our listeners, to the readers of our weekly blog, we’ll make that community of better decision makers together.
Karl Eggerss: Sure. Now, before you get out of here, I keep seeing biases, you’re saying biases, which ones right? Should we put it out for people to vote on? We want some feedback. Which ones right? Justin sounds more academic, mine sounds maybe more Texan, I don’t know.
Justin Pawl: I think it’s a good combination.
Karl Eggerss: All right, Justin Pawl, he is the chief investment officer at Covenant. Thanks for coming in, and come back soon.
Justin Pawl: Absolutely.
Karl Eggerss: All right, that’ll wrap up today’s podcast. Just a reminder, go to creatingricherlives.com. And if you’re getting our Covenant You distribution on Monday afternoons, feel free to share it with anybody you would like, and we appreciate you listening. And if you need our help to ten five (210) 526-0057. And again, this podcast brought to you by Covenant Lifestyle, Legacy, Philanthropy. Hey, have a good weekend everybody and we’ll see you back here next week on Creating Richer Lives.
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