The Allure of Overconfidence

I say what economists are supposed to say. I tell everyone who will listen that they should invest in index funds and then don’t check their balances. I explain that abnormal returns stem from abnormal information. Individuals are unlikely to have abnormal insight about publicly traded companies because other people have more time and resources to find that information. Further, even if a professional has abnormal insight, it’s not likely to persist over time. Index funds get around the problem of idiosyncratic risk and the brevity of abnormal insight by riding on the back of the more informed. I say all of this and I believe it in my heart.

I teach macroeconomics and I’ve published about asset volatility. I know more about inflation and the macroeconomy than the typical investor. From mid-2020 through now the S&P500 has gained 11.3% annually. My personal return has been 21% annually. It’s true, however, that the first half of 2022 was rough. But I can’t help but feel happy and confident.*

Specifically, I was mostly long on a well-diversified and very liquid index fund. And as I got a better ‘feel’ for the market (shhhh… Don’t tell the other economists that I relied on intuition), I applied and was approved to trade on margin. That allowed me to trade futures, options, and to borrow money from my broker. Don’t worry. I didn’t trade derivatives and neither should you. But I did go doubly-long when my preferred asset was periodically “too low”.

That is, when the asset price was low, I borrowed at an annual rate of about 7% and purchased more. Then, within two months, I sold. I did this a couple of times (And I’ve done it since in 2023). The holding period cost of funds tended to be about 1% and my holding period returns tended to be about 18%.

Stepping Back

Maybe I was lucky. I have nothing at my disposal that lots of other people don’t have. That’s what my training tells me. I did have some prudence on my side. Besides holding only cash for about a month, I ensured that I was only ever long on the market. The rationalist inside of me knows that the market has gone up in the long run and is likely to continue doing so. Worrying about short-run volatility is for the weak of heart and stomach. So, I always felt comfortable that I’d eventually be OK, even if things began to look bleak.

Another method for taming anxiety was scheduling trades well ahead of time. Following the news and markets and social media makes one feel as if, one way or another, now is the time to trade. So, I would schedule my trades and keep them open for upwards of two months at a time. Every time that I leveraged, I already knew the limit price at which I would deleverage. I largely ignored the most up-to-date information and emotions in favor of the more detached version of myself. I had to put a lot of trust in the previous version of me who didn’t have the day’s sudden changes on his mind. My mantra was that I just had to be more tolerant of volatility and more patient than others.

Being successful leads me to think silly thoughts. Maybe I should go work for an investment bank. Maybe I should start my own actively managed investment fund. If leveraging to go long makes sense, surely leveraging to short the market has a lot of potential too. I’ve got this thing figured out.

It’s not me, it’s…

I get to tell myself that I understand the macroeconomy better than others – especially fundamental concepts like inflation (even if I don’t). I’ve got letters after my name and everything. Maybe my excess returns are due to my exceptional insight. Maybe my insight will be less relevant and less of an advantage in a low-inflation environment. That is, I’ll fail to enjoy my higher returns once we return to a low inflation regime. Indeed, I should expect to have subnormal returns. I’ll have lost my edge over others. Or, maybe my strategy has nothing to do with inflation and is successful for reasons that I don’t know. Maybe I’m just lucky. Regardless, I can see why perfectly reasonable people can come to believe that they are good fund managers. Success breeds confidence. Confident success breed self-confidence. Self-confident success breeds overconfidence.

*The point is not to brag. I know that other people have higher returns than me.

One thought on “The Allure of Overconfidence

  1. Lucas Dennis March 16, 2023 / 7:27 am

    I bought frc at 20.90 and sold at 41.70. I would love to know your thoughts on government spending and the debt ceiling crisis. The government sector and business sector are very over leveraged at the moment as it relates to gdp. Instead of housing crisis, will we see a government and business crisis? The government won’t let itself fail OFC so will we see businesses fail tremendously to bail out the government as a result?


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