Finance 101: Bull markets

They make us look like geniuses.

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This run in the stock markets, over the past 20-plus months, has been pretty impressive. Since the lows in February 2016, global stocks, as measured by the ACWI global stock index, have returned 40 percent, which translates to well north of 20 percent annually. Not too bad. When we have these excellent returns for an extended period, we should rejoice. It’s not always that easy or fun. And not only were those returns terrific, they came with ever smaller zigs and zags in the prices of stocks and bonds. The calmness of the market has been historically low for a historically extended period of time. There simply hasn’t been any kind of setback, even small, in prices. So please be thankful.
But funny things happen when returns come so steadily and bountifully. People start feeling smarter. They’ve made lots of money — whatever they have been doing has worked. And just about everything has worked. Even small- and large-value stocks have awoken from a near-decade snooze. International markets have started outperforming the U.S. market. So if you were invested in stocks, regardless of how good or how poor your investment strategy was, it pretty much worked. You literally could have done all kinds of dumb risky things, and still come out smelling like a rose. It is difficult not to feel vindicated in one’s investing prowess and knowledge when this happens. And few care how well they did when they see they have made more money.  You need a certain, albeit small, amount of knowledge to find the investments to buy and create the story you tell yourself as to why our choices are the right ones. If they were successful, it had most likely more to do with luck and not skill. And that is a problem. 
This is what is called the confidence gap. I have always been interested in this phenomenon. And strangely enough, it seems more prevalent when the markets make strong, extended moves, as it is currently. When you have a shot glass of knowledge, it can easily lead you astray. So when I came across a recent blog post by Nick Maggiulli of the very good financial blog ofdollarsanddata.com, it was time to revisit this issue. 
Here’s one of the best passages: “There is evidence that having a little knowledge on a particular topic can lead to vast amounts of overconfidence. This overconfidence, in turn, can lead to bad decision making. In psychology, this is known as the Dunning-Kruger effect, or the cognitive bias in which individuals with low ability perceive themselves as having high ability.
“Dunning and Kruger found that after gaining a small amount of knowledge in a particular domain, an individual’s confidence soared. However, when that individual was provided with further training, they were better able to assess their skills, and their confidence dropped. It was only once their experience approached that of an expert did their confidence rise again.”
Candidly, I don’t think people with investments in the stock and bond markets should actually pursue being an expert. Your time is better spent becoming more of an expert in your chosen work, and trying to increase your income and savings. What you can do is start considering whether you should be investing the way you have been based on a possibly mistaken assumption of true knowledge. In the likelihood that this is true, then the knowledge you should pursue is how to create a sane and diversified portfolio. It will need to meet your goals over a long time horizon, with many different market conditions. You can do this yourself, or use an advisor, with the idea that you don’t have to be that smart to make smart decisions on how to invest.
The markets will, at some point, take back some, more, or all of the gains we have recently realized. And people operating within this confidence gap will be most unhappy and humbled, making them more prone to damaging mistakes than their less confident peers. Just recognizing that we may not be as smart as we think we are can keep us out of trouble.

John Kageleiry is a business writer and financial planner. Read more finance columns at veriumplanning.com. Have a question for “Finance 101”? Email it to john@veriumplanning.com.