By Vipul Prasad
Conviction is a common tool in investors’ behavioural toolkit. It indicates an investor’s level of confidence in his opinion—or more specifically, in his stock call or market call. However, conviction turns out to be counterproductive if it is excessive. High conviction regarding the future—even if it is based on sound fundamentals—can often grow into a millstone for an investor without he even realising it.
The problem is that conviction in an opinion cannot be, in itself, a sign of correctness of the opinion. High conviction may tell us the investor has constructed a coherent story, but it cannot give any indication regarding the probability of this story being true. Behavioural science experiments, on the contrary, prove that the more confident a forecaster is in his forecast, the worse his forecast turns out to be. High conviction is aided by the difficulty in accepting the limitation in our ability to forecast the future. This difficulty is rooted in our ability, in general, to construct coherent narratives for the past.
High conviction leads to overconfidence; that can manifest itself in many forms—overconfidence in one’s ability to forecast future earnings of a company, or to judge the management’s capabilities, or to buy a stock at a bottom and sell at a peak.
Even in other fields, overconfidence can muddle a decision-making process. For example, a patient due for a surgery gets comfort from the surgeon’s confidence. The patient typically will feel good if the surgeon is so confident that he just asks for an ultrasonography report and is all set for the surgery. But it will be more reassuring for the patient if the surgeon sends him for more diagnostic tests, say an MRI (magnetic resonance imaging), in order to get a better and richer perspective of the organ set to go under the knife. The surgeon, in the second case, is more likely to be prepared for a surprise on the operation table since he has assessed all the available information, rather than relying only on his conviction-driven instinct.
Overconfidence generally leads to callousness, even recklessness. Excessively frequent trading, holding on to a bad stock even if there is evidence otherwise, constructing an over-concentrated portfolio, taking liberties with an enshrined investment process, etc, are some bad outcomes of high conviction in investment management. High levels of conviction often lead to confirmation bias. Then whatever one does is seek confirmatory evidence, which can be self-defeating. Interacting only with analysts with similar stock views, exchanging views only with investors who prefer the same stocks, asking questions from company management to elicit the answers that reinforce existing opinion, etc, are some actions that follow. As conviction takes deeper roots, new information fails to add to the quality of forecasts.
Some investors buy a small quantity of stock with an aim to track it to assess if it is attractive enough for purchase of bigger quantities. The problem in this approach is that purchase of even a small quantity sparks off commitment to the stock. After that, the human urge towards consistency ensures the stock does not look unattractive even if there are reasons that suggest so. Thus, the purported exercise of assessing the stock for investment-worthiness unwittingly becomes a recipe for guaranteed perception of attractiveness. This, in turn, triggers purchase of bigger quantities of the stock—irrespective of prospects.
Further, high conviction prevents an individual from appreciating the role of luck in investing. It causes investors to overestimate their skills and underestimate the importance of temperament. Such hubris is often punished heavily by the markets. High conviction militates against probabilistic thinking—which mitigates risks, is more realistic, and keeps one prepared for more than one outcome.
Make no mistake, conviction is important for decision making, for focusing the thought process, for proper plan execution. But instead of becoming dogmatic, investors should use conviction to be spurred into ardent search for new perspectives and an urge to test opposing hypotheses. The key for an investor here is to keep an open mind. It is important to differentiate between explaining an event post facto, and predicting the future with its numerous uncertainties. Having strong views—especially if they are anchored to detailed research—is fine, but one should be ready with the flexibility required to change views if facts change, or if contradictory evidence appears. Generally, conviction in a stock makes us seek reasons to hold on to the stock. Instead, a better way is to research hard and see if we can find a reason to sell the stock. This process of inversion reduces risks for the portfolio.
Pre-mortem can be another way to avoid overconfidence and to shield the decision-making process from excess conviction. Investment management team should do this exercise once the decision to buy a stock has been taken, but before placing the order. In a pre-mortem exercise, investment team members have to assume the stock has been purchased, two years have passed, and the call has gone horribly wrong. Investment team members should, under these assumptions, write down a brief analysis of the stock call. Avoiding halo effect and group think, and evading confirmation bias, this exercise suppresses the negative effects of high conviction. The statement by Charlie Munger—the celebrated investor—that “I never allow myself to have an opinion on anything that I don’t know the other side’s argument better than they do” can be instructive in this context.
-The author is founder & CEO, Magadh Capital