Perspective on global equity markets through a behavioral finance lens

Confident to a fault

January 2017

Key takeaways:

  • The overconfidence bias can lead investors to take inappropriate risks, trade excessively, and overestimate the value of their insights.
  • Baby boomers seem to be more susceptible to the overconfidence bias than other generations when it comes to investment decisions.
  • Over the near-term, equities may prove vulnerable to investor overconfidence regarding President-elect Trump's ability to deliver on his campaign promises.
  • To help prevent the overconfidence bias from taking control, we suggest that investors balance their equity allocations against evidence that new policies and U.S. economic growth are materializing as forecasted.

Do investors always behave in rational ways that best serve their long-term interests? The dot-com bubble, the Great Recession, and the 2015 stock market stampede in China argue otherwise, illustrating the importance of understanding the cognitive, emotional, and social factors that can lead investors to make counterproductive decisions. This is the focus of behavioral finance. In my last quarterly investment insights, I discussed how the "hot-hand fallacy" can convince investors to maintain a previously winning strategy well beyond reasonable valuations.

Overconfidence is another cognitive bias, although one with emotional overtones. Research demonstrates that a majority of investors consider themselves better than average at making decisions, leading to an overestimation of their probability of success. The overconfidence bias seems partly responsible for financial market behavior after last November's election and could remain a factor in 2017. I discuss the overconfidence bias in this issue of my insights.

Unexpected financial market fallout

Academics, political strategists, "think tanks," and the media are among the many groups that have been sifting through data to glean insights from last year's unexpected U.S. election results. As with the political outcome, the financial market outcome differed substantially from initial expectations.

The "Trump trade"

As shown in the "Trump trade" chart below, the S&P 500® Index began November 2016 at approximately where it was in mid-April, and during the intervening six months most polls forecasted that Hillary Clinton would become the 45th U.S. president. By comparison, the general pre-election expectation under a Trump-win scenario was for a multiple-month-long flight to quality and stock market sell-off. Instead, equities and the U.S. dollar moved decidedly higher in the weeks immediately following the election, as the markets focused on the stimulus-related potential of Donald Trump's campaign platform and corresponding effect on U.S. economic growth. This helped the U.S. dollar, the S&P 500 Index, and the S&P 500 Banks Industry Group1 return 4.5%, 5.0%, and 23.0%, respectively, from just before the election through the end of 2016.

The overconfidence bias in action

Has the overconfidence bias played a role in these results? We believe so. Behavioral studies indicate that the validity behind an argument is easy to accept if it supports one's beliefs, while a contrarian point of view is usually treated with skepticism and hyperactive scrutiny. Similarly, incoming information tends to be viewed through a biased lens, and as information becomes pervasive—irrespective of whether it conforms to or conflicts with one's perspective—the effect tends to be one of polarization, driving viewpoints toward extremes. Under these circumstances, confidence regarding a potential outcome can quickly evolve into overconfidence.

Trump in the media spotlight

Although a favorable combination of fundamentals could pave the way for select U.S. stocks to reach record highs in 2017, we expect a bumpy ride along the way.

President-elect Donald Trump has remained in the media spotlight since the election, and so have his campaign promises. Trump's platform included the following: (1) increased fiscal stimulus, (2) decreased regulation, and (3) increased infrastructure spending. If realized, this combination could accelerate U.S. economic growth and corporate earnings growth, and has the potential to help counter concerns about political uncertainty in Washington D.C. and the potential for a more protectionist political stance for the U.S. However, history demonstrates that campaign promises can be daunting to achieve.

To the extent that the recent bull market is reliant upon investor overconfidence regarding Trump's ability to deliver, stocks may be susceptible to intermittent corrections, particularly if voters become impatient for policy results. Therefore, although a favorable combination of fundamentals could pave the way for record highs for select U.S. stocks in 2017, we expect a bumpy ride along the way as investor overconfidence regarding Trump’s policies potentially clashes with implementation reality.

Baby boomers may be at risk from the overconfidence bias in the current environment because of the values generally embraced by this generation.

Potential baby boomer susceptibility

Baby boomers may be at risk from the overconfidence bias in the current environment because of the values generally embraced by this generation. The developmental years for boomers occurred amid post-World War II economic prosperity, when money, title, and recognition at the office were coveted measures of success. This generation considers high self-confidence and a willingness to take calculated risks requirements for climbing the corporate ladder. These values may therefore make boomers more predisposed to the overconfidence bias than other generations. Moreover, research indicates that slightly more than 50% of this generation voted for President-elect Donald Trump,2 increasing the possibility that investors in this group are confident that Trump will deliver, translating into equity valuations that likely reflect this collective level of confidence.

Boomer financial market influence is global

As shown in the chart below, boomers owned more than 50% of mutual fund assets as of mid-2015.3 This generation's collective investment decisions therefore play a substantial role in shaping global financial market behavior. The dot-com bubble, Great Recession, and 2015 stock market stampede in China are relatively recent examples of when boomers influenced market outcomes through their collective investment decisions. In these instances, boomers unfortunately lost billions of dollars amid overconfidence that their investment insights were sharper than average and destined to generate better relative returns.

Millennials should also proceed with caution

Like the baby boomer generation, millennials—the largest living generation—are also susceptible to the overconfidence bias. Data tends to drive the decisions made by millennials. More than other generations, millennials tend to be educated, tech-savvy individuals who grew up during the digital age. Data-driven investment trading platforms and related algorithms therefore tend to make more intuitive sense to millennials than to other generations. Millennials also seem predisposed toward skepticism and tend to rely on social media and their own insights and research to spot trends, patterns, and potential investment opportunities. This fierce independence in a world overloaded with information can cause millennials to fall prey to the overconfidence bias. The reality is that we are entering an “unprecedented” presidential period in the U.S., with a relative lack of data and experience from which to draw conclusions and estimate potential results. Such an environment could leave millennials at a disadvantage.

On the horizon

As 2017 gets underway, we believe that select stocks and sectors could prove vulnerable to investor overconfidence regarding President-elect Trump's ability to activate his campaign platform. Talk is cheap after all, and it may take longer than expected for his intentions to be realized. This sets up the potential for intermittent volatility, particularly early in the year, as potential market overreactions could be prompted by how quickly the new administration’s policies begin to materialize and whether the incoming data support the outlook for faster U.S. economic growth.

The way in which the U.S. dollar behaves could also play a role in the equity market's performance. Currency markets seem aligned with the latest international developments. If the dollar continues to strengthen, this would reflect expectations for additional rate hikes by the Federal Reserve, a faster pace of U.S. economic growth, and a more historically average pace of inflation. However, if several of these factors fail to materialize as quickly as is expected, the U.S. dollar could remain flat for now. Looking internationally, the Bank of Japan and the European Central Bank appear ready to begin reducing their economic stimulus efforts, implying potentially better growth forecasts and prospects for companies in Japan and the euro zone. These developments could affect the value of overseas investments in U.S. dollar terms, and are worth monitoring as 2017 unfolds.

With this backdrop in mind, we believe that investors should critically evaluate whether their confidence in the near-term outlook for stocks may have become overconfidence. Underestimating risk and chasing returns can take hold when the overconfidence bias asserts itself, potentially leading investors to miscalculate the value of their insights, trade excessively, and detract from the long-term performance of their portfolios. In addition, we think that investors should balance equity market valuations against current reality, and wait for evidence that additional fiscal stimulus, decreased regulation, and infrastructure spending are beginning to materialize. In other words, employ a disciplined, long-term approach and try to avoid falling prey to the overconfidence bias.

Omar Aguilar, PhD
Chief Investment Officer, Equities and Multi-Asset Strategies
Charles Schwab Investment Management
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