Wednesday, September 13, 2023

Memo to Investors: Beware of the 'Comfort Zone'

By Herb Greenberg (View Archive)

I have this saying that we're all making it up as we go along, with some people simply better at bluffing than others...

Some call that imposter syndrome, but it's really little more than what occurs if you push yourself so far that you rise to the level of your incompetence… hopefully knowing when you've hit it..

That's how we build experience... but also how we gain confidence or our interpretation of whatever confidence is.

The trick is not to become overly confident.

That's an important nuance when it comes everything we do, but especially investing and business.

Avoiding that trap is a focus of my friend Peter Atwater's recently published book, The Confidence Map: Charting a Path From Chaos to Clarity...

Peter is probably best known to Empire Financial Daily readers as a contrarian's contrarian. But his day job is as a professor at William & Mary College and the University of Delaware, where teaches classes on confidence and decision-making.

In other words, Peter knows a thing or two about confidence.

The Confidence Map is an effort to make intellectual sense of why we do what we do based on whatever level of confidence we have... or lack thereof.

It's a detailed exceedingly deep dive into four different levels of confidence... from confidence to take risks to overconfidence.

Obviously, everybody's interpretation of confidence is subjective, and as Peter writes, can be “squishy”...

But understanding where you are on the confidence scale can result in better decision-making. But more importantly, it can help improve the outcome of perhaps the two most important things that go into creating confidence – certainty and control.

That's easier said than done, especially with investing, which I liken to buckling into a roller-coaster car without knowing how long the ride will be or what the track ahead looks like. (Unless of course, you're buying U.S. Treasurys and to hold them until maturity.)

Even then, after a streak of wins, it's easy to get overconfident. That’s why whenever stocks start rising wildly old timers (yeah, like me!) often repeat that old saying: "Don't confuse brains with a bull market." A tired old cliché. Absolutely, but it has stood the test of time for a reason. As Peter puts it...

The more confident we feel, the more rose-tinted our glasses, and the less apt we are to go looking for or put stock in counter arguments. We limit our view to belief-affirming evidence.

We've all been there, and will likely be there again.

To map the various stages of confidence, Peter uses a box with four quadrants...

The comfort zone is in the upper right – that's where we're probably the most comfortably confident and the happiest. But my takeaway from Peter's book is that for investors, the comfort zone is potentially the most dangerous place to be...

And not just comfort zone, but the far reaches of it... in one of Peter's quadrants below, the far upper right side. Like confetti falling to celebrate an IPO at the Nasdaq.

It's why one day you can feel like a genius, and the next day, a dope... and why with investing, as I often say, hubris can be so humbling.

Peter puts it a little more eloquently, and in a bit more context, when he writes...

Invulnerability doesn't get discussed much, but it is a much more useful lens than overconfidence through which to view and understand our behavior in the upper reaches of the Comfort Zone. "Overconfidence" suggests that we have too much of something – that we over-believe, especially in our own abilities.

In fact, what drives our behavior is our under-beliefs. We underappreciate, and therefore overlook and dismiss, any and all threats. We underappreciate the potential downsides to our decision-making. We underappreciate the potential harm we may experience. All this underappreciation is why scrutiny tails off the more confident we become.

And as he goes on to say (emphasis added)...

At our very peak in confidence, we believe those feelings will be permanent. What marks the top ­– whether for a market, a sports team, or a leader – is the extreme extrapolation of invulnerability. We believe we will stay unscathed forever. Not surprisingly, not only does our accompanying behavior look ridiculous in hindsight, it naturally sets up the precipitous collapse in confidence that follows thereafter.

While they appear unshakeable to the crowd, environments of invulnerability are extremely fragile. Systems and processes are designed around the belief that extreme certainty and control will exist in perpetuity and that nothing will ever go wrong. Everything is hyper optimized for efficiency. Every safeguard is tossed aside.

When something begins to go wrong, as it inevitably does, then scrutiny reintensifies, the ensuing collapse exposes the structural hollowness of the situation. With that, environments of invulnerability all but implode, collapsing under their own weight. Too much optimistic abstraction rests on far too little real substance.

That's typically the point when things start going off the rails, and when people feel too certain and too in control of what's ahead.

That's exactly when fear of missing out takes hold, and investors start believing the frauds, fictions, and fakes...

As Peter writes (emphasis added)...

With scrutiny all but nonexistent and the jovial crowd believing it is invulnerable, opportunities abound for the unscrupulous to profit.

You'd think we learn, but we don't. Every market mania provides examples. In the 1820s, it was Gregor MacGregor, who charmed the crowd into investing in Poyais. Amid the dot-com bubble, the leadership team at Enron duped investors and regulators with fraudulent accounting practices, a playbook followed more recently by Bernie Madoff and the folks at Wirecard.

And sometimes, at the very peak in manias, the scams are all but in plain sight. Just before the cryptocurrency bubble burst in 2021, investors were falling all over themselves to buy "sh*tcoins" – digital currencies with little to no value and/or no immediate, discernable purpose.

And let's not forget the meme stocks and special purpose acquisition companies ("SPACs").

Overconfidence happens to the best of us, but understanding why might help avoiding it next time around.


Herb Greenberg
September 13, 2023

P.S. Rather than get sucked into the hype of those frauds, fictions, and fakes amid bubble-like behavior in the markets, I'm more interested in real businesses with real products and real cash flows.

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