Readers know that I’m a fan of Ted Lucas of Lattice Strategies. He recently wrote a piece (Applied Risk Strategy 1-21-13 – Humble Confidence and Creativity) discussing the impact of overconfidence on performance, as well as why a good risk management process should involve anticipating how assets behave in certain environments (in other words, predicting future volatility) – a task that requires both creativity and humility (awareness of what you don’t know).

Psychology

“Indicators of overconfidence (said differently, lack of humility):

• Self-serving attribution bias – people attributing success to their own dispositions and skills, while attributing failure to external forces or bad luck
• Self-centric bias – individuals overestimating their contribution when taking part in an endeavor involving other participants
• Prediction overconfidence – the overestimation of the accuracy of one’s predictions
• Illusion of control – belief that one has more influence than is the case over the outcome of a random or partially random event.”

Interestingly, in the study referenced, the results showed that neither overconfidence nor over-trepidation were conducive to superior performance in the future. Perhaps we are at our decision making best when striking a fair balance between “gumption” (as Charlie Munger calls it) and healthy skepticism.

Risk, Volatility, Creativity, Psychology

“We need to look no further than the financial crisis five years ago to conclude that statistical artifacts like an asset’s historical beta or volatility – which are, respectively, the orthodox risk measures employed in Modern Portfolio Theory and its handmaiden tool, mean-variance optimization – fail to capture many far more critical elements of risk… A comprehensive philosophy of risk also seeks to understand the conditional dynamics of risk as the backdrop evolves – how do assets respond during varying risk regimes (particularly the most turbulent periods), and across changing macroeconomic contexts?”

“Effective risk allocation – the primary driver of long-term portfolio returns – is at heart a design problem…The most productive efforts here are likely to be those benefiting from the constraint of personal and predictive humility and the cultivation of humility’s companion, expanded creativity.”

For risk management, Lucas advocates that investors pay attention to how “assets respond during varying risk regimes” – something I interpret as anticipating future volatility. Not an easy task and one best approached with healthy doses of both creativity, and humility (awareness of what you don’t know).