This article was originally posted on The Harvard Business Review’s website.
By Kari Firestone
One of the tenets of sensible risk taking is to be skeptical of promises and projections. Yet this is hard to do in practice. We’re surrounded by people (and companies) exaggerating their skills or knowledge or features — and we’re often guilty of it ourselves.
This behavior is called “overclaiming,” and research suggests that it is tied to how individuals perceive their competence. A series of studies found that having some subject-matter expertise can lead people to overestimate their knowledge. So when people believe that they have a strong understanding of a subject — say, finance — they tend to overclaim more, asserting that they know concepts that researchers present to them, even when the concepts are made up. Rather than saying that they don’t know what something is (the nonsense term “meta-differential collateral credit,” for example), they claim to understand the bogus concept, whether it is a financial instrument, a medical device, or a chess move.
This tendency matters for a couple of reasons. Today we consume more and more information, and we do it faster and often without adequate reflection and concentration. Because conversations move quickly, there’s pressure to respond immediately and deliver instant results. This makes us more likely to overclaim, and it is partly why we allow others’ exaggerations to influence our choices — whether it’s for a presidential candidate claiming to make America great again, a real estate agent who insists the property will never lose value, or a hedge fund manager who promises his track record could never falter.
I recently encountered an illustrative case of overclaiming that could translate easily across industries. After one hedge fund I know had a horrendous quarter, the managers wrote to clients, saying that they were concentrating 70% of the entire fund into only five stocks. The managers explained that a recent plunge in prices provided them a rare opportunity to temporarily increase concentration in their strongest areas, which they were sure would soon increase sharply in value. They described this situation as offering lower risk and higher potential return for investors.
The managers desperately wanted to regain their losses, and the trust of their clients. But their action was similar to poker players doubling down on what they believe to be a good hand: They think they have exceptional cards, or in this case, stocks. A hand of four aces is always a winner, but it’s a hand that no one playing the market legally can claim to have.
In my world of portfolio management, it was an extremely risky move, and a perfect example of overclaiming that should make anyone skeptical. It has beenproven that the average volatility of an index, comprising many stocks, will be lower than that of its individual components. Therefore, the statement that a very concentrated portfolio would have lower risk cannot be correct. It is also highly unlikely that the fund’s clients — individuals, institutions, and endowments — would want to increase their risk.
The managers said this course of action would result in higher returns. However, any manager who claims unequivocally that placing the majority of their fund’s assets in a handful of names will enhance performance must have virtually error-proof judgment (highly unlikely). A very concentrated portfolio won’t help if the whole market collapses. And an unpredictable black swan event, such as an explosion in a major factory or oil drilling platform, can hit any company. In other words, the fewer the names within one portfolio, the more vulnerable it is when any one name drops in value. The clients exposed to this overclaiming face increased financial risks if these scenarios unfold.
The overclaiming we see here puts clients at real financial risk. The managers should have admitted the mistake, taken the loss, redistributed those assets, and maintained diversification across industries and different stocks that they believed have strong potential.
Overclaiming occurs everywhere: a biotech CEO saying that the company’s tests can determine various diseases from a drop of blood; a marketing executive insisting that she can double her sales from last quarter; a football coach telling his players that they are definitely better than their opponents.
What matters is being able to differentiate between bold claims that may be true and those meant to create an aura of excitement, seduction, and enthusiasm about something that the audience can’t resist. Marketing and advertising claims bombard us constantly, and although we often tune them out, we need to extend our skepticism to overclaimers whom we are inclined to trust.
To avoid making poor choices as a result of overclaiming, be skeptical if:
What you’ve been told sounds too good to be true
You feel the person is trying to intimidate you into not asking questions
You ask a few questions, but the person can’t address them or you don’t understand the answers
Only when you are comfortable and confident with all the information you’ve received should you make a decision. In the case of the concentrated hedge fund, I would ask specifically how long the manager planned to follow the new strategy before returning to historic allocations, what returns they expected during that period, and how their clients should judge them over the next few quarters. If the answers are vague or confrontational, I would put in for a redemption. There are countless situations in which you’ll have to deal with overclaimers. Learn to adopt a skeptical approach.