ISMS 8: Larry Swedroe – Are You Overconfident in Your Skills?

Mar 9, 2023

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In this episode of Investment Strategy Made Simple (ISMS), Andrew and Larry discuss a chapter of Larry’s book Investment Mistakes Even Smart Investors Make and How to Avoid Them. In this first series of many, they talk about mistake number one: Are you overconfident in your skills?

LEARNING: Don’t be overconfident. Look for value-added information when researching an investment.

“When you trade, understand that you’re competing against the market’s collective wisdom.”

Larry Swedroe

In today’s episode, Andrew chats with Larry Swedroe, head of financial and economic research at Buckingham Wealth Partners. You can learn more about Larry’s Worst Investment Ever story on Ep645: Beware of Idiosyncratic Risks.

Larry deeply understands the world of academic research and investing, especially risk. Today Andrew and Larry discuss a chapter of Larry’s book Investment Mistakes Even Smart Investors Make and How to Avoid Them. In this first series of many, they talk about mistake number one: Are you overconfident in your skills?

The majority of people are naturally overconfident

There’s a lot of research showing that human beings tend to be overconfident in their skills. If you ask people, are you liked by others more than the average person? Are you a better lover than the average person? Can you drive better than the average person? It doesn’t matter what the question is; the answer from a vast majority is that they think they’re better than the average person. According to Larry, this is actually a good healthy thing. Imagine getting up daily, looking in the mirror, seeing yourself, and thinking you’re dumb, ugly, stupid, and nobody likes you. You’d live a sad life. So it’s good to feel better about yourself as long as you don’t make mistakes.

Overconfidence isn’t such a good trait when it comes to investing

Larry says that the market is made up of all types of investors. If some investors are going to outperform, then some investors must underperform. The market must have victims to exploit. Most investors tend to be overconfident and think they’re a lot smarter than the average person, so they will be able to control them. But according to evidence, that’s dead wrong because people are not competing one-on-one.

Female investors get better returns than men due to underconfidence

Women are not better at stock picking than men. The stocks they buy perform just as poorly as those that men buy. And the stocks they sell go on to outperform in equal measure. However, men have overconfidence in skills they don’t have, while women simply know better. They don’t overestimate their skills as much as men do, so they trade less and have fewer turnover costs, resulting in better returns. Interestingly, married women do worse than single women because they get influenced by their husbands, while married men do better than single men because they have the influence of the sage counsel of their spouses.

Does hard work, training, and knowledge play any role in outperformance?

Generally, the more knowledge you have, the wiser you become. But the game of investing is very different than, say, the game of tennis, where you’re playing one-on-one. During a one-on-one match, whether tennis, chess, or any other similar game, minor differences in skill lead to considerable differences in outcome. As the competition gets more challenging, it becomes harder to win. And luck becomes more determined.

According to Larry, when we’re playing a game of investing, we’re not competing one-on-one. We’re competing against the collective wisdom of the marketplace. That’s a much different competitor. That’s why Warren Buffett today has difficulty keeping up his winning streak of the 80s.

The second related mistake is when researching a company, a famous person or a newscaster gives investors enticing information about a company he’s touting, and the investor decides they should buy that. They’re confusing information from this person with value-added information. They assume they’re the only ones who know this information. Yet thousands of other people could be watching this famous person or newscaster. The truth is the average person doesn’t have value-relevant information, and they’re competing against the market’s collective wisdom, which is a much tougher competitor than one-on-one. This is why only a few active managers can outperform persistently.

Know who is on the other side of the trade before you execute

Whenever you buy a stock, you should stop before you execute and ask yourself who’s on the other side of the trade. Ninety percent of the trades are done by sophisticated institutions that hire world-class mathematicians and scientists with PhDs in finance, invest in massive technology, and have more access to information than an individual investor. So are you seriously going to be overconfident and believe you know more than these institutions?

Investing has become a lot harder than it was 20 years ago

Larry says investing is much more complex today and will continue getting harder. There are several reasons why this is the case.

1. Increased financial innovations

Before the 1980s and around 1990, the only operating model we had for asset pricing was the capital asset pricing model (CAPM). This model could only explain about two-thirds of the differences in returns of diversified portfolios. This meant there were tremendous opportunities to generate alpha.

Along came a bunch of researchers who found two characteristics that added explanatory power. One of them was that small stocks outperform large stocks. The other was that cheap stocks outperformed expensive stocks. So now, on top of CAPM, there were two other factors: size and value. Now investors could no longer claim to outperform just by buying small companies.

Research by Jegadeesh and Titman found a momentum factor. This was that stocks that had outperformed in the past six months to a year roughly had a tendency—a bit more than half the time—to continue outperforming over the next short period, on average, five-six months. So now active managers couldn’t claim alpha by buying positive momentum stocks, avoiding negative ones, or shorting them.

Then in 2013, Robert Novy-Marx wrote a paper on profitability. He found that you could outperform your position by buying more profitable companies—Just as Warren Buffett did.

Most recent research by Cliff Asness and the team at AQR combined profitability with other factors related to what Buffett had been saying; you shouldn’t just buy cheap, profitable companies. You want to buy them when their earnings are more stable. Such companies don’t have a lot of financial leverage, making them quality companies. So now we have a factor called QNJ: quality minus junk. So you buy the quality stocks and short the junk ones.

With all these financial innovations in place, investing as an individual gets harder because stock selection strategies are not a privilege to a select few. Anybody can invest in small-cap stocks en masse. Therefore anybody can capture that alpha or cause it to disappear.

2. Increased financial knowledge and competition

There was no financial theory until the late 60s and early 70s. People managing money were not finance majors and didn’t know finance theory. Today, everyone managing money has easy access to financial knowledge. With increased knowledge comes tougher competition and the paradox of skill. When competition is tougher, it becomes harder to differentiate yourself.

It’s the smarter, more informed people playing the game now making it harder for others to outperform by a wide margin.

3. Retail investors have been channeled into hedge funds

For there to be winners in the market, there must be victims to outperform. In 1945, after World War 2, 90% of all stocks were held by individual investors in their brokerage accounts. So they were doing most of the trading. There were only 100 mutual funds in the US in the 1950s. Today those numbers are entirely reversed. Most of the trading is done by institutions. This means when you’re trading, you’re likely trading against giants like Renaissance Technologies, Citadel, or Morgan Stanley. Whereas in the 40s and 50s, you were trading against another naive investor. Today, retail investors have been channeled into funds managed by the most innovative people.

4. Dollars are growing while sources of alpha are shrinking

The sources of alpha are continuously shrinking while the supply of dollars chasing them has grown dramatically. In the late 90s, there was $300 billion in hedge funds. Today, there’s over $5 trillion. On the other hand, the sources of alpha are shrinking because the academics have converted into beta—which is just a systematic characteristic that’s replicable. It’s no wonder it’s becoming harder and harder to trade.

Will the largest hedge funds remain the top players, or will another group rise in the next 10 years?

Larry predicts that the largest hedge funds, such as Renaissance and Citadel, will grow as more people go into systematic passive strategies. A few active managers who are becoming successful will likely continue to gain market share. This is likely to create a problem for the managers. This is because the only way they can continue generating alpha is to stop taking assets. Otherwise, they’ll get too big and have to diversify or increase their market impact costs. Very few managers will turn down the chance to earn higher AUM fees.

Final thoughts from Larry

Don’t be overconfident. When you’re overconfident, you’ll think you can outperform when the odds say you’re not likely to be able to do so. Also, don’t confuse information—something everybody knows—with value-added information—something nobody else knows or you can interpret better.

About Larry Swedroe

Larry Swedroe is head of financial and economic research at Buckingham Wealth Partners. Since joining the firm in 1996, Larry has spent his time, talent, and energy educating investors on the benefits of evidence-based investing with an enthusiasm few can match.

Larry was among the first authors to publish a book that explained the science of investing in layman’s terms, “The Only Guide to a Winning Investment Strategy You’ll Ever Need.” He has authored or co-authored 18 books.

Larry’s dedication to helping others has made him a sought-after national speaker. He has made appearances on national television on various outlets.

Larry is a prolific writer, regularly contributing to multiple outlets, including AlphaArchitect, Advisor Perspectives, and Wealth Management.