When it comes to pinpointing the reasons for investment success and failure, being objective is a surprisingly difficult thing to do. Recognising precisely what went right and wrong can help in making better decisions in the future. The trouble is that humans tend to credit their ups and downs to reasons that aren’t always the case. In short, we like to take the credit for success and blame something else for failure. This is a well known flaw called self-attribution bias, and being aware of it could cut the risk of costly overconfidence and lead to a better investment process.
How athletes explain performance
Self-attribution has been studied in a wide range of settings, including investing. But a good place to start in getting to grips with its impact, is sport. Here, psychologists have looked hard at whether winners differ from losers in the way they explain their performances, and it turns out they do…
In his book Sport and Exercise Psychology, cognitive psychologist Aidan Moran says that in contrast to losers, winners in sport tend to credit themselves and the factors they control (like their preparation and practice). On one hand, this is important because it builds confidence in the mind of the athlete. But the problem is that self-attribution overlooks the possibility that the athlete might have won against inferior competitors. As such, the ‘win’ may not be quite as successful as it seemed.
On the flip-side, losers tend to blame external factors and make excuses, which is something you often find with football managers. You end up hearing quotes like: “I personally put our bad start to the season down to the new stadium.” Or perhaps: “It wasn’t our fault we lost the game, I thought it was his fault [the ref’s] on a decision he made not to give a free kick.” Moran says this effort to deflect blame is made to preserve self-esteem and present a more favourable image to others. Yet, blaming others misses the point that poor athletic performance or tactical errors may have had much more influence on the result.
Self-attribution in investing
One of the key takeaways from sports psychology is that self-attribution inflates confidence in athletes, even if it’s unwarranted. The same goes for investors. Research shows that successful investors don’t attribute enough of their success to chance or outside circumstance. In fact, the better they do, the more they credit themselves. This is exactly what was found in a study in the Netherlands of investors using a large discount brokerage. It found that the higher the returns in a previous period, the more investors agreed with a statement claiming that their recent performance accurately reflected their investment skills (and vice versa).
Research into excessive confidence among investors is extensive, but work by professors Brad Barber and Terrance Odean has linked it to the risks of acting on misguided convictions and overtrading. In fact, overtrading has been highlighted as one of the biggest potential risks of overconfidence because it can severely damage returns as a result of the high fees incurred. As they note in their research: “Overconfidence increases trading activity because it causes investors to be too certain about their own opinions and to not consider sufficiently the opinions of others.”
Like a lot of the behavioural pitfalls in investing, self-attribution can be addressed with some simple steps. Leading names in this field, like James Montier and Michael Mauboussin, see the solution as being a simple as keeping track of personal mistakes and successes. Montier suggests the use of a trading diary. He reckons that “only by cross-referencing our decisions and the reasons for those decisions with the outcomes, can we hope to understand when we are lucky and when we have used genuine skill, and more importantly, where we are making persistent mistakes.”
Mauboussin takes a similar line, claiming that investors “dwell on the outcome without appropriate consideration of process”. He points to the following table as an illustration of how, because of probabilities, good decisions will sometimes lead to bad outcomes, and bad decisions will sometimes lead to good outcomes. But over time, process dominates outcome.
In behavioural finance, self-attribution falls into a category of biases that are collectively labelled ‘self-deception’. As seen with winning athletes and losing football managers, it’s a challenging problem to overcome because it’s so natural to feel self-congratulatory about winning (whilst finding just about anything else to blame for losing). So tackling self-attribution means making the distinction between being right for the wrong reason and wrong for the right reason. Keeping a note of the real reasons for successes and failures should cut the risk of overconfidence and ultimately make for a better investment process.