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Dizzy with success

Joseph Stalin was right, at least in one respect. This is one lesson of Vladimir Putin’s so-far unsuccessful invasion of Ukraine.

People, said Stalin, “not infrequently become intoxicated by successes; they become dizzy with success” and so come to “overrate their own strength”. Which seems to have been Putin’s error. Having successfully annexed the Crimea in 2014 he thought he could do the same in Ukraine, especially as he thought the “historic unity of Russians and Ukrainians” (the title of an essay he wrote last year) meant Russian troops would meet little resistance.

But what’s this got to do with investing? Plenty, because company bosses, fund managers and retail investors are all prone to the same error. We become dizzy with success, and get high on our supply.

For example, having successfully acquired NatWest, Fred Goodwin – then chief executive of Royal Bank of Scotland (RBS) – thought he could repeat the trick with ABN Amro, ignoring evidence that the payoffs on takeovers were often negative. That decision caused the near-collapse of RBS. Goodwin, like Putin, had become dizzy with success – with disastrous consequences.

His was not an original error, however. As long ago as 1986 Richard Roll proposed a “hubris hypothesis” of takeovers; bosses become overconfident about their ability to merge businesses and so pay too much for acquisitions.

Neil Woodford made a similar mistake. Having performed brilliantly for years at Invesco Perpetual he too became dizzy with success and moved away from what Charlie Munger calls his “circle of competence” (investing in listed companies) to buy small unquoted businesses. You know how that ended.

The mistake, though, is not always a high-profile one with catastrophic costs. It’s widespread among retail investors too, and bad for us.

The problem arises from the self-serving bias – our tendency to attribute success to our own skill but failure to bad luck. Arvid Hoffmann and Thomas Post at Maastricht University have shown that after high returns investors are more likely to say that their performance accurately reflects their investment skills than they are after their returns have been poor. In fact, even after only a few days of good returns investors will see skill where there is in fact only luck. Economists at Ohio State University have found evidence of day traders in foreign exchange markets (a mug’s game) “attributing random success to their own skill”.

Of course, being overconfident about your ability isn’t necessarily disastrous. It’s certainly not in the job market where employers actually select overconfident candidates. Nor need it be in investing, if it encourages us to run our winners thereby benefiting from momentum effects.

Sadly, however, the effects of overconfidence don’t stop there. Becoming dizzy with success leads us to trade too much, and as Brad Barber and Terrance Odean showed in a classic paper, this is hazardous to our wealth. This isn’t just because of dealing costs. It’s also because if you are trading often you are acting upon noise rather than signal and so are in effect simply gambling at bad odds.

What’s more, if you come to believe it is easy to beat the market you’ll take too much risk by underinvesting in safe assets and by overinvesting in more speculative stocks that have poor average returns.

We’ve good evidence that overconfidence is systematically bad for us. Su Shin at the University of Utah and Andrew Hanks at Ohio State University studied thousands of Americans aged over 50 and found that those who were overconfident about their intellectual skills were significantly less rich than others, even controlling for obvious causes of such differences such as education or income. “Overconfidence has a negative impact on net worth,” says Shin.

In fact, of course, we’ve known about the dangers of overconfidence for centuries. The word 'hubris' comes from the ancient Greek. And the second-century author Tertullian warned those enjoying great acclaim to “hominem te memento”: remember you are human, with all our flaws.

We now know that these flaws are many: thanks to the work of Nobel laureate Daniel Kahneman, we have a long inventory of errors of judgement.

Mere brain knowledge of these errors is, however, not enough. Instead, what we need are institutions and habits that entrench the avoidance of known errors, just as Ulysses tied himself to the mast of his ship to avoid the temptations of the Sirens. In companies and governments, such institutions must protect against groupthink and overbearing overconfident bosses. And for retail investors, it must consist of habits that stop us trading too much, acting on our emotions or taking too much risk. One of the few merits of playing golf is that it stops you from trading.

Now, you might think it offensive to compare a war criminal to people whose only crime is to lose money. Morally, there’s no equivalence. But intellectually there is. Investing is not a discrete activity separate from the rest of life. It is an exercise in judgment under uncertainty. Deciding whether to buy a share, take over a company, start a war or simply to play an attacking shot at cricket are all manifestations of the same general problem, of how to choose. And the error of overconfidence can be common to all of them. Investing is part of life – which is why it is so interesting.