Spending time at home during the lockdown here in New Zealand might be a good opportunity for self-reflection. Something that we did not appreciate enough at the start of our careers was nicely summarised by Aswath Damodaran in a recent podcast:

Our decision-making can be clouded by what psychologists call behavioural biases. Biases play a role in different aspects of our lives, but we believe they are particularly important to address when it comes to investing. In this article we discuss one of these biases, overconfidence, and why it is important to consider it in manager research.

Overconfidence

In technical terms, overconfidence means that you are not able to accurately predict your own probability of success.¹ Put more bluntly, if you are overconfident you think you are better than you actually are.

It is not hard to imagine how this could have a negative effect on the way a person picks stocks, forecasts the direction of markets, or selects fund managers. However, overconfidence has not just cost investors money, it also contributed to one of the most spectacular collapses in the history of financial markets: Long-Term Capital Management (LTCM).

Raising the stakes

Best described as a hedge fund, LTCM was considered an absolutely stellar investment manager in the mid-nineties. LTCM had two Nobel prize winners and a group of brilliant traders and investors that spun out of Salomon Brothers. Their performance, mainly focused on arbitrage and convergence strategies, was spectacular for a few years – but then it all collapsed within weeks in 1998.

Reading about the downfall² it is obvious that overconfidence played a significant part in the firm’s demise. LTCM used an extraordinary amount of leverage (28:1) to finance its positions and almost always doubled down on trades that went against them, ignoring the possibility that they may have made the wrong call.

Of course, it is easy to attribute overconfidence in hindsight. But interestingly, some red flags were in the public domain long before the fund even started. According to Michael Lewis³, LTCM’s founder John Meriwether once countered a bet to play a single game of poker for a million dollars, by saying that he would agree to play it for ten million dollars instead. Does that sound a bit overconfident to you?

Culture versus overconfidence

The example illustrates why we believe it is crucial to interview fund managers as part of the manager research process. A lot can be missed when you are doing simple desktop reviews or analysis of past performance alone. Who is the person in charge of looking after your money? A thoughtful investor or an overconfident gambler? Did the fund manager get lucky on the last hand or are they following a repeatable process?

At Makao, we check for a number of biases in our assessment of Culture and Skill. For Skill, we consider how fund managers reflect on their own mistakes, for example. And for Culture, we try to determine how much decision makers value the input of others, among other criteria. In our opinion, a diverse and inclusive culture can be vital for keeping behavioural biases under control. However, there are other antidotes as well that we have experienced in our research.

In one of our interviews, a fund manager explained that they were conscious that a certain part of their universe of stocks was traded through a different valuation lens compared to what they used themselves to identify value. Rather than blindly following their own views, they showed some awareness for other perspectives.

While confidence in your investment process is important, some humility can often go a long way. Sometimes it is helpful to pause and ask yourself: Are you paying attention to what others think – outside of your bubble?

There’s more to the game

There are numerous biases that have been researched and assessed, including problems with how we interpret and process information (cognitive errors) and whether we let our emotions get the best of us (emotional biases, like overconfidence). Having some understanding of these issues and how they affect you can lead you to better decision-making, we believe.

Behavioural biases apply to individual investors, fund managers and – looking in the mirror – investment consultants. We believe it is important to be mindful of the potential biases you have in your approach and try to install a process and culture that can minimise their impact.

¹ For a technical and comprehensive discussion of biases it is worthwhile to consider reading the classic “Thinking, Fast and Slow” by Daniel Kahneman.

² “When Genius Failed, the Rise and Fall of Long-Term Capital Management”, Roger Lowenstein.

³ “Liar’s Poker”, Michael Lewis.