Confidence and Our Perceptions of Certainty
There is another related aspect to mood that I think is also worth considering, and that is the fact that our mood/confidence level and our certainty about the future are highly correlated. That is to say that the greater our own level of confidence, the more certain we are as to what we think the future will hold. Interestingly, too, the greater our confidence, the more into that future we think we can see our own version of that future as well. Put another way, when we are confident we think we know what is ahead, and when we are really confident we think we know what is ahead for a very long time to come. Companies, for example, routinely overinvest at the top in manufacturing capacity because they are certain of strong demand well into the future. The net result for most people resembles Figure 1.1, in which there is a near-perfect correlation between our level of confidence and our level of certainty of the future world around us.
Figure 1.1. Our self-confidence and our outlook on the future are tightly correlated...
Source: Financial Insyghts
The reality, however, is that the future is in no way correlated to our level of confidence. The future is going to be what it is going to be whether we are confident about it or not. Although our preparation and attitude might improve our ability to cope with what the future holds, as much as we may want—and at times truly believe—otherwise, our level of confidence won’t determine what is ahead. I try to capture this in Figure 1.2 with the horizontal line.
Figure 1.2. ...but the future is what it is and we over-extrapolate at the extremes in mood.
Source: Financial Insyghts
To me this is an important element of mood—particularly for investors—because, as Figure 1.2 suggests, it introduces the clear potential for us to over- and underestimate what is ahead due to changes in our level of confidence. I’ve come to think of this as our “hopeful delusion” when our mood rises and our “fearful delusion” when our mood falls. But as if that weren’t bad enough, the more positive or negative our mood, the more we are naturally inclined (for better and for worse) to extrapolate those delusions into the future. Take one look at analyst earnings estimates and price targets at a major peak or trough of a stock and you’ll see precisely what I mean. Few groups fall victim to the extrapolation effects of “hopeful delusion” and “fearful delusion” as repeatedly as the equity analyst community.
The more confident we are, the more into the future we think we can see and the more we extrapolate our current assessment of what we see as certain into future periods. And when our confidence and mood are extremely high, we naturally foresee great things ahead for some time to come.
The opposite, however, is true as our level of confidence deteriorates. In those times, we do the reverse and extrapolate more and more negative outcomes further and further out as our mood drops. Without even realizing why it is the case, we see things as becoming more and more hopeless. I have no doubt, for example, that at the very bottom of the Great Depression most Americans thought life would be uncertain forever—an extreme example of the extrapolation of fearful delusion.
As you’ll see, these delusions play a critical role in our preferences and in our decision-making processes. They are a key underlying element to both asset bubbles and panics. They also bring into serious doubt whether we or any market are really ever truly rational at all!