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The Risk of Being Overconfident

The very best investors know their limitations. Most investors pretend they know.

Samuel Lee, 04/08/2013

According to a study by hedge fund firm AQR, Warren Buffett’s stock portfolio, estimated from the Berkshire Hathaway BRK.B quarterly 13F filings, beat the market by about 2.4% annualized from 1991 to 2011 (“Buffett’s Alpha,” 2012). The highest-returning large-cap U.S. equity mutual fund over the period, Calamos Growth CVGRX, beat the S&P 500 by about 4.5% annualized.

Even if you are very good—among the best— you can reasonably expect only a few percentage points of extra return over decades-long spans in a highly competitive market like U.S. large-cap equities.

Why, then, do investors spend so much effort trying to be clever, neglecting the fundamentals? Keeping bonds in tax-sheltered accounts likely adds more value than trying to find the next Apple AAPL. The all-consuming quest for alpha is a symptom of overconfidence. More specifically, it is a failure to stay within one’s “circle of competence.”

This is a big reason many investors fail to achieve their investment goals. Investors stray outside their circles. I did it myself when I first started investing. I bought shares of Bank of America BAC without even knowing how to analyze financial statements and the competitive dynamics of the banking industry. I had no business picking individual stocks then, and I have no business picking them now. There are a lot of incredibly smart people picking stocks full time, and they say it’s hard. I believe them. I’d feel presumptuous thinking I can do it better.

Finding Your Circle of Competence
“Above all, I guess you’d say we have
a strong sense of our own limitations.”
—Warren Buffett

This is not to say you or your clients shouldn’t own individual stocks or bonds. If you have good reason to believe you have an edge or if it’s “fun money,” go for it. But I certainly wouldn’t plan my clients’ retirement on my ability to outsmart the market. What are your advantages? Most investors don’t have many. I can think of two sustainable ones: not being constantly measured against a benchmark, freeing the investor to pursue long-term opportunities, and investing with a small capital base, opening up less-liquid, more lucrative opportunities.

These edges will always exist, even though everybody knows about them. Professional investors will always control the majority of assets, and they will always be measured quarter by quarter. The pros can’t act as “patient” capital, which can ride out bubbles and swoop in to buy during terrifying times like the financial crisis. Good investors by definition compound assets quickly, and other investors like to give them their money to manage, so good investors’ capital bases tend to outgrow small, illiquid opportunities. There’s hope for the brave and clever individual investor. Unfortunately, studies suggest most individuals do not exploit their advantages.

Samuel Lee is an ETF Analyst with Morningstar.
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