Swinging and Investing Despite Overconfidence Bias

If you’re a bogey golfer, you’ve probably had your share of three putts (and sometimes four), but I’m willing to bet you haven’t experienced anything like what happened to Dustin Johnson at the 2015 U.S. Open.
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That year Johnson found himself on 18th green trailing Jordan Spieth by one stroke with a 12-foot eagle putt to win.

Statistically speaking, Johnson had a 90% chance of making either the first or the second putt. If he made the first, he would win and net himself his first victory at a major. If he made the second, he would force a playoff with Spieth, and still be in the running.

He made neither.

Johnson would three putt and end up finishing tied for second.

That day on the 18th green, Dustin Johnson turned statistical probability on its head.

Playing the Odds

When it comes to numbers, our brains encounter some problems. They’re just not wired to comprehend probabilities. So, when we hear things like “90% chance” or “there’s a 1 in 500,000 chance of getting struck by lightning” our brains make a generalization about the probability of that event happening.

When we hear 90% chance, we think “that’s a sure thing.”

When we hear 1 in 500,000, we think “that will never happen to me.”

But in real life, that’s not how it works.

In the case of Dustin Johnson at the U.S. Open, he was going to miss both of those putts on 1 out of 10 occasions. It just so happens that 2015 was that one occasion.

Same thing applies to lightning strikes. Hundreds of people are actually struck by lightning every year.

This phenomena is called overconfidence bias, and it’s pervasive in all aspects of our lives, including investing.

Overconfidence in Financial Markets

Market corrections, defined as a 10% decline from the most recent high, can be unnerving. Just think about how you felt last March when the S&P 500 was down more than 12%.

However, if I told you that the S&P 500 experiences a correction once every ten years, or only in 10% of years, you would probably feel pretty comfortable. Your sentiment would also be completely misguided because my statement is entirely false.

In fact, over the past two decades, the S&P 500 has experienced a correction in 11 years out of 20 years, or more than half. Market corrections are an extremely frequent event, and they will happen to you.

If you’re a mid-career professional, still saving for retirement, these pullbacks can be a great opportunity, because you have time on your side, but if you’re approaching or already in retirement, they can be quite nerve-racking.

What do you do?

Putting the Odds in your Favor

If you are a golfer, weather is out of your control and will undoubtedly play a large role in your experience on the course.

Likewise if you’re an investor. Volatility is out of your control and will undoubtedly play a large role in your experience in the markets.

Benjamin Graham, a much smarter investor than me, said, “The purpose of the margin of safety is to render the forecast unnecessary.”

To put it another way, if you pack your rain gear and your sunscreen then you don’t have to worry about the weatherman’s forecast next time you tee it up.

From an investment perspective, your margin of safety has a lot to do with your cash flow and time horizon. Here are a few things to consider before the next time you tee up a trade:

  • Your emergency fund is your sunscreen and rain gear. You won’t always need it, and that’s the point. It’s there for emergencies. Put it in your bag (or your savings account) and don’t touch it. You’ll be happy it’s there the next time you go for it.
  • Distance from your target matters. Big swings are great for drives; they’re not so great for putts. The closer you get to your target, the smaller your margin for error becomes. Decreasing volatility is important as you get closer to your goal.
  • Don’t imitate the pros. Whether it’s a swing tip you saw on social media or a trading strategy on TV, before you implement, evaluate it in the context of your own goals and objectives. What works for someone else might not always work for you.

Want more?
Here’s a short highlight reel from the 2015 U.S. Open where you can watch Dustin Johnson’s infamous three putt.

We just hosted our most heavily attended webinar about planning for uncertainty in the markets. You can check out a replay now.

Judson Meinhart, CFP®, BFATM, MBA
Financial Advisor, Manager of Financial Planning


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