Psychologist Daniel Kahneman on Avoiding Overconfidence

A common problem that we run into as investors is overconfidence in our estimates. Sometimes because we put so much effort in our calculations we believe that they must be correct. As the next example proves, it is only on a few occasions when our estimations of the near and far future turn out to be correct.

"For a number of years, professors at Duke University conducted a survey in which the chief financial officers of large corporations estimated the returns of the SP500 Index over the following year. The Duke scholars collected 11,600 such forecasts and examined their accuracy. The conclusion was straightforward: financial officers or large corporations had no clue about the short-term future of the stock market; the correlation between their estimates and the true value was slightly less than zero! When they said the market would go down, it was slightly more likely than not that the market would go up. These findings are not surprising. The truly bad news is that the CFOs did not appear to know that their forecasts were worthless."

I find this to be interesting because if CFOs, who are aware (hopefully) of the financial conditions of their companies and industries in particular, cannot forecast accurately what will happen with the market, I believe that it is naïve to think that macro forecasts are: 1) easy, 2) fundamentally sound and 3) accurate. Getting to know a company is certainly the way to go, with the final steps being understanding how the current and future economic environment might impact its profitability. This, coupled with the concept of margin of safety, is the way to go to avoid overconfidence.

With this in mind, I think top-down investing is hard, but possible with Ray Dalio (Trades, Portfolio)'s Bridgewater being the best example I can think of. Some of the greatest investors of all time have taken their stance regarding the macro approach:

“I don’t read economic forecasts. I don’t read the funny papers.” –Â Warren Buffett (Trades, Portfolio)

“Nobody can predict interest rates, the future direction of the economy or the stock market. Dismiss all such forecasts and concentrate on what’s actually happening to the companies in which you’ve invested.”–Â Peter Lynch

“Gigantic macroeconomic predictions are something I’ve never made any money on, and neither has Warren.”–Â Charlie Munger (Trades, Portfolio)

• Ray Dalio Undervalued Stocks
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