At the 1989 Berkshire Hathaway shareholders meeting, Buffett said that he had recently received a letter from the daughter of David Dodd. Dodd’s daughter wrote that her father thought it was important to know your limitations. Buffett added that this was one of Dodd’s favorite themes.
“Knowing your limitations” has been studied by behavioral finance, which has labeled the lack of this virtue overconfidence bias. Numerous studies have shown our strong inclination towards this bias, even when we are made aware of its presence. It seems to be a kind of useful short-cut mechanism from a utilitarian perspective that is used in everyday life when there is nothing really riding on expressing a particular point of view, for example, predicting the outcome of a football game.
This bias is practiced so frequently, and it is so psychologically ingrained, that it can be a real challenge to check it when you are dealing with something that requires absolute accuracy grounded in facts. Its stubborn presence has been a material factor in everything from airplane crashes to botched medical procedures. Check lists have been recognized as a surprisingly simple and effective way to counter this bias.
Investing is an art that has no place for overconfidence bias and many fortunes have been lost as a result of it.
Investing presents a particular problem because it inherently involves making predictions about the future based on imperfect information. Moreover, greed acts as a kind of magnet drawing us towards an imagined positive outcome, even if our conclusion about the probability of that outcome is not grounded in facts.
The trick in fighting this bias is to be brutally honest about what you know and what you don’t know. This is where knowing your limitations comes in. You must first isolate what you really know and then determine if it is enough to make a prediction. If not, you should take a pass. If it is, then, according to Buffett, your task essentially comes down to determining the chance that you are correct times the amount of possible gain minus the chance that you are wrong times the amount of possible loss.
One useful thought experiment is to imagine giving a presentation on your investment thesis to a group of knowledgeable industry executives. Could you do it? Write down your thesis. Share it with another savvy investor.
One other word of caution. Big money is made by taking meaningful positions when you are certain the odds are in your favor. This requires a high degree of certainty. You can delude yourself into thinking that you know what you’re doing by only investing a trivial amount in a stock relative to your net worth. This is why Buffett says that diversification is a hedge against ignorance. The more you invest this way the more likely it is that your returns will equal that of a stock index. Put another way, taking only small positions is a way of perpetuating overconfidence bias because you can pretend you know what you’re doing when in fact you’re really speculating.
Outstanding Investor Digest, June 23, 1989, pages 5, 6.