Three words rarely heard in the investment business are perhaps the most important to long-term success.
Because the future is unknown and having the humility to admit that we can't predict it is very hard for us to do. We're wired instead with overconfidence - we overestimate our abilities when it comes to sports, driving, investing, and many other areas of life.
While a little bit of confidence can be a good thing in many areas of life, overconfidence, particularly in the investment world, can be disastrous. With overconfidence comes the tendency to overtrade and make highly speculative, concentrated bets on the future.
Many studies have shown that these attributes tend to lead to lower overall returns. The more confident you are, the more you trade, and the worse your returns are on average…
Source: Barber and Odean (1999)
And interestingly, as men tend to be more overconfident than women, they tend to trade more (45% according to one study) and have lower risk-adjusted returns (1.4% less on average). The old saying "boys will be boys" seems to apply to investing as well.
What's the best way for investors to manage their overconfidence?
- Diversification: not putting all of your eggs in one basket.
- Resisting the urge to trade.
- And sticking with a broad asset allocation plan.
Boring, I know; not nearly as exciting as letting it ride in some cryptocurrency. I completely agree, but successful investing is not supposed to be exciting or entertaining. By diversifying, you're removing your ego from the equation and accepting the fact that you're not likely to pick the next Amazon or make the next Big Short.
To the contrary, you are saying three important words when it comes to making precise predictions or forecasts about the future: I Don't Know.
Let's practice this concept in response to some standard questions you hear on financial TV every day:
Where will the S&P be at the end of the year? I don't know.
Where will the 10-year yield be at the end of the year? I don't know.
Where will Crude be a year from now? I don't know.
Is Gold a good investment here? I don't know.
Will the U.S. enter a recession next year? I don't know.
What will be the best-performing stocks/sectors/asset classes over the next day/month/year? I don't know.
How many times will the Fed hike over the next year? I don't know.
You diversify because you don't know the answer to these questions. No one does.
As an investor today, you don't know if the 9-year expansion/bull market will end this year or continue for a few more years. You don't know if U.S. stocks will continue to crush international/EM in the years to come or finally start to lag. You don't know if the 35-year secular bull market in Treasury bonds is over or if yields will turn down once more. You don't know if the Fed will hike rates once, twice, or more over the next year and what impact if any that will have on markets. You just don't know.
In any given year, predicting which asset class will be at the top and which will be at the bottom of the performance rankings is a fool's game (see table below). No one can do it with any consistency.
But that's alright because as luck would have it "knowing" (or more accurately, thinking you know) the future is not a prerequisite to making money in markets. In fact, just the opposite is true: admitting you know nothing is your best weapon as it will push you towards long-term diversification (higher probability outcomes) and away from making overconfident short-term bets (lower probability outcomes).
So don't be afraid to say, "I don't know." In the business of investing, it's probably the most honest and helpful thing you can say.