How would you rate yourself as a driver? That is the question I always open with when I teach as a practitioner lecturer on the Private Wealth Management programme at Nyenrode Business University. Without exception, the majority consider themselves above-average drivers. Hardly anyone rates themselves below average. That cannot be true, and yet it happens every time. Investing is not much different.
Entrepreneurs who have sold their business and are managing a large fortune for the first time run into this too. With one big difference that matters a great deal. They have the proof that they were right sitting in their bank account, or so they think. Yet the overconfidence behind that thought is a potentially serious pitfall.
Overconfidence is an earned trait
Anyone who was proved right almost every time in the same market for thirty years is entitled to self-confidence. That is not a cognitive error; it is accumulated knowledge and hands-on experience. The problem arises when that knowledge and experience are projected one-to-one onto investing. ‘I am a successful entrepreneur, so I am a successful investor too.’ No. If only it were that simple.
Various studies show why entrepreneurs, despite their business success, can make systematic mistakes as investors. Their wealth was built through entrepreneurship, specialist knowledge of their sector and taking business risk. Preserving and growing that wealth calls for very different skills. Three things need to be kept apart. Business success: the ability to build a company and make it succeed. Investment skill: the ability to outperform an appropriate benchmark over the long term, on a risk-adjusted basis. Wealth preservation: the ability to manage concentration risk, liquidity, tax and the transfer of wealth. And therein lies the rub. The first does not automatically prove the second or the third.
Wealth is not proof of insight
A study of 2,484 American millionaires is telling here: it found that their expectations of financial markets were surprisingly similar to those of average American households. Wealth, in other words, is no automatic proof of superior financial insight. Which brings me to the work of Barber and Odean at the University of California. They studied the results of tens of thousands of private investors and concluded that the group that traded most often performed worst. Overconfidence leads to more trades, more trades lead to higher costs, and higher costs mean lower returns.
Nobel laureate Daniel Kahneman, author of Thinking, Fast and Slow among other works, said that if he could wave a magic wand and remove one cognitive bias, it would be overconfidence. Overconfidence has several dimensions. Overestimating what we know, overestimating how much more we know than others (and that our information is ‘better’), and overestimating the precision of our own forecasts. In your own business, all three may hold true. Outside it, rarely.
The network is the temptation
After a sale, deal flow often arrives of its own accord. Even if you do not want it. The private bank, the former colleague, the entrepreneur friend who is also backing a new start-up. Solicited and unsolicited, investment proposals come your way. Often from people you trust. Others have already looked at it, done the analysis and are in. Three signals that are each reassuring on their own, and together are actually very dangerous. It is called herd behaviour, and it is instantly recognisable. We follow the crowd without forming an objective view of our own. Add peer pressure, and you give in without even noticing. Welcome to the curious world of behavioural economics.
Challenge can be organised
The answer is not to tame the entrepreneur. The question is: how do you protect someone from their own reflexes, in their own interest? This is almost always a question of design. Is an investment policy in place before an opportunity presents itself? What do we want to invest in, what do we definitely not want to invest in, and how are investment decisions made? Families that get this right have an investment committee with at least one member who earns nothing from the deal and owes the family nothing. Every proposal is weighed against the agreed investment policy, and if it does not fit, it is turned down. No is also an answer.
Who at the table may say no
Drawing up a good investment policy is not difficult. The challenge lies in how decisions are actually made in practice. Who is at the table? And who has a vote? Often the founder chairs the investment committee, and the founder rarely meets his match. He built the fortune, and everyone knows his view before he has said a word. That is precisely the environment in which groupthink thrives. Dissenting views are swallowed out of loyalty, out of deference, or so as not to spoil Sunday lunch. This is a common pitfall. Anyone who sends away the people who tell him what he does not want to hear has a recipe for failure. In a family, nobody sends anyone away. People simply stay silent to keep the peace. Organised challenge therefore ideally comes from outside, and has to be agreed before it is needed. So the question is not which investment you make tomorrow. It is this: who may say no at your table, and when did that person last do so?