Conviction vs Overconfidence: An Example From Microstrategy

There is a fine line between having conviction in a security (or portfolio) and being overconfident. The former is a positive quality typically found in disciplined and thoughtful investors. The latter is fueled by emotions, ego, and typical of irrational investors. How do we define that line and make sure we are on the correct side of it?

A Real Time Example – MicroStrategy

The Wall Street Journal reported last week that the CEO of MicroStrategy has stepped down due (in part) to significant and costly bets he made with company money on Bitcoin. Even after amassing significant losses in Bitcoin, and putting the company close to financial peril, Michael Saylor remains a Bitcoin bull. Is this because he has strong conviction in Bitcoin or because he is overconfident?

I honestly don’t know, but it brings up several valid questions. What is the difference between conviction and overconfidence? One is admirable another is irresponsible. How do we know? And how does the outcome bias play into evaluating the difference?

Beware of the Outcome Bias

Whenever we are faced with choices (which is in just about every aspect of life), we often evaluate the quality of our decisions based on the outcomes. If the outcome is desirable, we say it was a good choice. And vice versa.

In the 2015 Super Bowl between Seattle and New England, Pete Carroll called for a pass (rather than an expected run) just yards from the end zone that was subsequently intercepted, solidifying a win for New England. Everyone judged it to be a terrible call…because the outcome was undesirable. However, if you listened to Pete’s reasoning after the game, the decision was very thoughtful and may have statistically been the correct one. But, because the play resulted in an unfortunate outcome, it was deemed a horrible decision.

We face similar decision-making challenges with investing. Several months ago, Saylor’s bet on Bitcoin looked like a great move. As Bitcoin soared, MicroStrategy stock price increased significantly. Because of his extreme conviction (or overconfidence) in Bitcoin, he didn’t sell any on behalf of the company. Not even sufficient to take the principal off the table. Now the company faces financial hardships. If in the long run Bitcoin (and MicroStrategy) do very well, then most people will laud him for his conviction. If the company goes bankrupt, he will likely be called an irresponsible CEO whose overconfidence drove the company to its grave.

Applying it to Me and You

So what does this mean for us normal investors? Unfortunately, defining what is conviction and what is overconfidence is not easy, even in hindsight. We will be tempted to define intentions through the outcome bias, but that could lead us to erroneous conclusions. Understanding the ambiguity between these two can help us be more mindful of their effects on our decision-making process.

Since we cannot easily identify what is driving our choices, perhaps a few questions can help us make more thoughtful decisions in line with our stated objectives. This would diminish the need of identifying whether we are exhibiting conviction or overconfidence.

  • Is the proposed investment in line with my investment strategy and risk tolerance?
  • If I am completely wrong, what is the downside? Would that materially impact achieving my financial goals?
  • Is my conviction/overconfidence based on research and empirical evidence or influenced by hope and conjecture of an awesome gain?
  • Given my answers above, does it make sense to invest in this security? If so, what would be an appropriate amount?

Answering the questions above may seem pretty straightforward, but responses may be driven by unconscious feelings and/or cognitive shortcuts. Talking through the above reflective questions with your advisor can help you get it right. You may not like the end result. But this is really about which you want more. Is it more important to you to be right or to get it right?

Related: Earnings Season is Here. Investors Shouldn’t Care