To invest well, know your limits and admit your mistakes

First, a quick announcement. I’ll be hosting the Carnival of Personal Finance next Monday! Many followers of this blog probably discovered me through the Carnival, and I’m really proud to be giving back a little bit by hosting this week. I have a newfound respect for the people who’ve put it together and will try my best to make this carnival excellent. To that end, I hope you can help too by blogging about it, tweeting it, facebooking it and doing whatever you can to promote it. I’ve never solicited such publicity before, but this time, it’s really about all the great posts the carnival will feature, rather than about Pop Ec. But on to our regularly scheduled programming…

What happens when making mistakes becomes a capital offense?

Longtime White House reporter and columnist Helen Thomas resigned earlier this week. In case you haven’t paid attention to the case, she told a website catering to the Jewish population that Jews should “get the hell out of Palestine.” I don’t really want to talk about the statement, whether or not it was bigoted, and whether she deserved to lose her job over it.

However, I was disturbed by the piling on of criticism from seemingly every pundit and retired politico who could get a reporter on the phone. Ari Fleischer, Bush’s first press secretary, e-mailed journalists who might have missed her comments to call for her firing. This is a guy who currently runs a sports marketing business. Clearly, Thomas had built up some enemies during her time in the White House press room.

Thomas apologized almost immediately, but it was too late.

So how is this relevant to investing, economics, and all that other stuff you read about here?

Thomas was wrong. And instead of acknowledging it, correcting it, and moving on, we forced her to retire.

Reuters blogger Felix Salmon had a great piece on this trend earlier this week. The long and the short of it was this: “It’s still unacceptable, in public discourse, to be wrong in one’s opinions. I find that sad.” He went on to describe an interview with atheism promoter Christopher Hitchens, who refused to directly admit that he has ever been wrong or could be wrong in any of his opinions.

Having to be right is a plague

I’m fairly sure that I’ve made at least one error in every blog post I’ve written since starting Pop Economics this January. Some of them are easy: I wrote about how mortgage rates would go up in March in one particularly bold (and wrong) post. Some errors are more slight: I change my mind on whether active or passive investment strategies are superior almost every other week. So at least half of those posts are wrong.

I know none of those errors are incendiary like Thomas’ comments, but imagine if at least some of you decided to take off for another blog after discovering that I had made a mistake or flip-flopped on a position. I’d have a serious problem on my hands. Indeed, it’d be tempting not to admit any errors at all.

Investors are overconfident.

I know I make mistakes. And that’s why I didn’t put all my money into ETFs that bet Treasury bond yields will go up, even though I was almost certain that would be the case in March. It’s why I write about value investing with passion, yet don’t commit more than 5% of my own portfolio on betting that the market is over or undervalued.

I’d say my most confident evaluations of any given stock’s true value have only a 55% chance or so of being right. And I bet Warren Buffett would say his most confident evaluations wouldn’t be that much higher. (Incidentally, I’ve probably just made a mistake even in that modest calculation of my chances.)

But your average investor has a worse overconfidence problem than I do. Economists have repeatedly demonstrated that we put way too much belief in our predictions and abilities. In a famous 1981 survey of Swedes, 91% said they were above-average drivers.

An article in MIT’s Sloan Management Review describes a survey conducted of professionals in various industries. Each were given a 10-question quiz on their own industries that asked them to give high and low estimates in response to certain questions, such as “How many patents were issued in the U.S. in 1992?” (The survey was conducted in the mid ’90s.) The right answer was 96,727. So a respondent could give any range that encompassed that figure and be correct.

They were told to give ranges that gave them about a 90% of getting the question right. But when the quizzes were evaluated, the professionals tended to miss more than 60% of the questions asked. Their overconfidence caused them to set ranges much too tight.

And they’re slow to change direction after being proven wrong.

Investors have extremely peculiar views on profits and losses. If you bought BP at $60 and watched it drop to $30, somehow you tell yourself that the loss doesn’t “count” unless you “lock it in” by selling. So maybe you hold on, hoping it will recover a bit.

Economist Tyler Cower writes that we tend to place a greater value on something because we own it. In other words, a share of BP at $30 per share seems more valuable when it’s registering in your ETrade account than when it’s just running through the ticker on CNBC. It reminds me of playing Monopoly games when I was younger. When you asked a kid under the age of 12 to part with even his most insignificant properties, say Oriental, he would ask for a ridiculous sum in return. And so no one would trade with anyone, and I’m pretty sure that game is still ongoing.

But a couple economists from Yale and Princeton have come up with another theory, which they’ve called “realization utility“. In short, they’ve determined that an investor derives more pleasure from actually selling a stock and reaping the profits than he does from simply seeing the stock price go up on his ETrade account (and vice versa for losses). The sale of the stock (and money in the account) serves as a validation that he or she made a right decision. And you could assume that the sale of a stock when it’s lost value would be a confirmation that he made a wrong decision. As long as he doesn’t sell, he doesn’t have to admit the problem.

It’s a dangerous wonderland to end up in — where not looking and not correcting seems superior to admitting a mistake. And while it’s definitely a culture that we’ve begun to build up in America — ok, maybe the Helen Thomas lead in was a bit of a stretch — I hope it’s not one that you’ll fall into when making important decisions with your money. Cause when it’s time to retire and sell that fund or stock for rent money, the landlord’s not going to much care that you held on to escape admitting a mistake.

Tagged as: behavioral finance, Investing, media, Personal Finance