FiduciaryNews

Detecting These Signs of Overconfidence Can Help 401k Investors Avoid a Fall

December 03
01:47 2013

Hubris. It’s the one tragic flaw of every Greek hero. It’s often mistaken for mere arrogance, a fatal trait if there ever was one, but it’s much more than that. It’s an extreme form of pride that causes one to exaggerate one’s abilities. As with 338158_6008_arrogant_bird_stock_xchng_royalty_free_300all things Greek, hubris extends well beyond the healthy moderation of self-confidence into the unrealistic illusion of invulnerability. The tragedy, to borrow from Shakespeare, is when hubris causes a hero to be “hoist on his own petard.” Metaphorically, the Bard has Hamlet turn the tables on his enemies through this metaphor of having the bomb maker to be blown up by his own bomb (petard). This is what Hubris can do. It also represents the third of three “over” retirement investments should try their best to avoid.

We’ve already covered “Over”-cautiousness and “Over”-diversification. This third common investor mistake comes from “over”-confidence, a.k.a., “hubris.” It’s the polar opposite of over-cautiousness. Whereas over-cautiousness keeps people from buying during historically low markets, over-confidence keeps people from selling during historically high markets. Both reactions suffer from what behavioralists call “recency” – i.e., the propensity to overemphasize the most recent phenomena and extrapolate near-term data well beyond its tendency to return to the mean.

Interested in learning more about over-cautiousness, then read “3 (Bad) Reasons 401k Investors are Over-Cautious

Overconfidence infects both amateur and professional investors, although many will say professionals are more likely to be overconfident and amateurs are more likely to be over-cautious. It can manifest in many ways. One example of overconfidence is relying on a theory far beyond its ability to successfully predict outcomes. This occurs when such theories move from the category of theory to that of myth. Brian P. Beck, President & CFO at Wealth Management Group of North America, LLC in Farmington, Connecticut says, “‘Simple’ rules, rules of ‘Thumb,’ canned investment advice from ‘Financial Advisors’ on TV, can really hurt an investor in the long-run. Investing is not an exact science and no one has come up with the ‘perfect’ investment strategy, not even Warren Buffett.”

For example, there was once a theory that said funds with lower expense ratios produced better returns than funds with higher expense ratios. It turns out this is only true for index funds, not actively traded funds (which represent the greater bulk of the fund universe). Ozeme J. Bonnette, Financial Coach at Tri-Quest Investment Advisors, based in Fresno, CA, says “There are so many myths about which funds are better or worse than others. They are often all misleading, whether the myth relates to high versus low expense or index versus active management, for example. Expense ratios are only one element of the analysis. The bottom line is that investors have to compare apples to apples. One can’t compare an international fund to a domestic fund, or a bond fund to an equity sector fund. Compare funds against their peers and their respective benchmarks. Understand the management and the management style. Know how the managers are being compensated. (Will they get bonuses for besting their peer group, which may lead them to take chances with their investments?)”

Want more? Try this: “A 401k Must Read: Mutual Fund Expense Ratio Myth Busted

The Department of Labor hasn’t made it easier for 401k investors, either. The new 401k Fee Disclosure Rule, without a template approved by the DOL, leaves the participant looking only at the data out of context. Despite the DOL’s warning not to look at fees alone, participants will look at fees alone – for better or worse. David Rae, Vice President of Client Services with Trilogy Financial in Los Angeles California, says, “I’ve run into quite a few people who have almost their entire 401k in company stock often because it has no fees. While I do believe you need to consider fees when looking at investments, that shouldn’t be the only way you pick an investment. Bottom line, it’s not what you make but what you keep. The net of fees number is way more important than just the basic fee being paid.”

Thankfully, most people don’t have to worry about investing their retirement money in company stock, a form of overconfidence 401k participants are most susceptible to. This kind of hubris leads you to invest a disproportionate amount of your retirement savings into the stock of the company that employs you. Not a good idea. Chris Chen, of Insight Financial Strategists, LLC in Arlington, Massachusetts tells us a tragic tale we should all pay attention to. “In the case of my client, he was fully invested in the company stock, and would not diversify away because he thought that it was too good of an opportunity to pass up. Eventually when the stock price peaked, he had nearly $1 million in the company stock in the 401k. Then the stock started sliding, and sliding. When he finally got out of it, he had $50,000 left. To rub salt in the wound he was laid off. Eventually the company filed for bankruptcy.”

The more widely understood example of overconfidence is the simple refusal to believe “no tree will grow to the sky.” You begin to hear this phrase more often when the market approaches historic highs. People begin to create ever more fantastic (i.e., unrealistic) scenarios to justify not selling. As a result they stay in the market straight through its most precipitous drop. This happened to many people at the end of the dot-com bubble in 2000-02 and at the end of the real estate bubble in 2008-09.

Notice what one word appears during both of those periods – “bubble.” A growing bubble is a sign of overconfidence. The one problem, though, and the reason so many people believe “this time it’s different,” is because it’s terrible difficult to predict just when a bubble will burst. Furthermore, market cycles tend to complicate any analysis. One style of investing (e.g., growth) might approach a bubble while another style of investing (e.g., value) remains undervalued. This is what happened in the 2000-2001 period. Growth investors, who had their salad days in the late 1990s, drew negative returns for three straight years (2000-2002). Value investors, while lagging (but not negative) in the late 1990s, found they had positive returns in 2000 and 2001. (Just like the 2008/09 market debacle, nobody escaped the Post-9/11 market decline in 2002.)

Interested in learning more about over-diversification, then read “The 2 Least Understood Investment Rules that Most Hurt 401k Investors

Perhaps the best way to avoid being a bomb maker who is blown up by his own bomb is to avoid being a bomb maker in the first place. For 401k participants, this may mean relying on either direct or indirect investment advice from a professional. David Rae, Vice President of Client Services with Trilogy Financial in Los Angeles California, says, “An advisor is also there to help you avoid the slew of other mistakes that investors make that greatly decrease their odds of becoming financially independent.”

Hubris will tell us of the sweet smell of our own sweat. It can also make us think we can outsmart the market. Neither are true. But it does reveal how awful hubris can be. For you see, the worry petard derives from the Latin peditum, which means, uh, shall we say, “to break wind.” Indeed, the word Shakespeare actually wrote – petar’ – wasn’t cut off merely to appear poetic. It was purposely used as a pun for a word that in those times meant flatulence. And, with that, if you didn’t realize how unbecoming overconfidence was before you read this article, hopefully that etymological fact will stun you back into reality.

 

Mr. Carosa is available for keynote speaking engagements, especially in venues located in the Northeast, MidAtantic and Midwestern regions of the United States and in the Toronto region of Canada.

Interested in learning more about this and other important topics confronting 401k fiduciaries? Explore Mr. Carosa’s new book 401(k) Fiduciary Solutions and discover how to solve those hidden traps that often pop up in 401k plans. The book also contains a series of chapters on this subject, including how to create an investment policy statement that defines a set of menu options consistent with the “one portfolio” concept (as well as leaving room for those few remaining do-it-yourselfers).

About Author

Christopher Carosa, CTFA

Christopher Carosa, CTFA

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2 Comments

  1. Lawrence Zeller
    Lawrence Zeller December 04, 18:08

    HI Chris,
    Thanks for another great article. I just want to note that in the second paragraph, in your statement that “over-confidence keeps people from selling during historically low markets”, I think the word “low” should be “high.” BTW, I REALLY like your article about the correlation between low fees and performances only applying to index funds. That was enlightening.
    Larry

  2. Christopher Carosa, CTFA
    Christopher Carosa, CTFA Author December 04, 20:21

    Larry – Thanks. Correction made.

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