In this series of posts we are looking at how understanding behavioural finance can help you make better investment decisions. In this post we'll look at the dangers of overconfidence.
This information is taken from our free report Beyond Greed and Fear, to download a copy please just click here.
Overconfidence
A decision-making bias that humans are prone to is overconfidence (i.e. overestimating your ability to successfully perform a particular task). Psychological studies show that, although people differ in their levels of overconfidence, almost everyone displays it to some extent. For example, way more than half the population claim to be above average drivers, or have an above average sense of humour.
There is also an inclination for individuals to place too much confidence in their own investment decisions, beliefs and opinions. Lack of confidence is paralyzing, self-confidence is good, but overconfidence is deadly. Overconfidence can cause real problems for investors who mistake luck for skill. For instance, when something turns out well after a decision we’ve made, we claim the credit.
However, when something goes badly, we tend to see this as just bad luck. Many investors fall into the trap of believing that they can pick winning investments. As a result, they sometimes put too much of their wealth into one single investment, such as a company stock, which can be very risky. Research shows that picking winning investments is incredibly hard to do, even for professional investors.
Investors with too much confidence in their skills often buy and sell too frequently, which can have a negative effect on their returns. Overconfidence manifests itself when we think we can out-guess the market in terms of short-term movements, resulting in us trading actively, trying to capture each mini-peak-and-trough. Unfortunately, that usually just leaves active traders poorer.
A fine line between confidence and overconfidence
In a 2006 study entitled ‘Behaving Badly’, researcher James Montier found that 74% of the 300 professional fund managers surveyed believed that they had delivered above-average job performance. Of the remaining 26% surveyed, the majority viewed themselves as average. Incredibly, almost three quarters of the survey group believed that their job performance was average or better.
Clearly, only 50% of the sample can be above average, suggesting an insanely high level of overconfidence in the fund managers surveyed. As you can imagine, overconfidence is not a trait that applies only to fund managers. Keep in mind that there's a fine line between confidence and overconfidence. Confidence means realistically trusting in your own abilities, while overconfidence usually indicates an overly optimistic assessment of your knowledge or control of a situation.
How to avoid overconfidence
To avoid overconfidence in your own investing, we suggest you document and review your investment record. It's easy to remember your one stock that gained 50% in a single day, but records may reveal that most of your investments are under water for the year. Understanding the psychology that causes us to act overconfidently will help you avoid it.
Before we really understand something, we may either lack confidence or express overconfidence. A common type of overconfidence stems from inexperience. For instance, more than 70% of naive investors wrongly assume that they are enjoying above-average returns. Also bear in mind that professional fund managers, who have access to the best investment/industry reports and research in the business, can still struggle at achieving market-beating returns.
Human beings are not rational
As we've discussed in this series of posts, psychological research has documented a range of biases that can affect decision making when it comes to money and investing. These biases sit deep within our psyche and, as fundamental parts of human nature, they affect all types of investors, both professional and private. Understanding them can help you to work around them.
Modern portfolio theory is built on the assumption of a rational being, who is unaffected by emotions such as greed, anxiety, regret, hope and fear. This super-rational investor simply does not exist. Everyone sees the world from a perspective which is uniquely theirs, and investing is no different. People have individual goals, requirements, desires, fears and hopes for their wealth.
What is your financial personality?
We all have different habits, different people we trust for advice, and different beliefs about the right decision on any occasion. But we all exhibit very similar psychological biases in our financial decision making, which can lead to poor portfolio choices and subpar investment performance.
Understanding your financial personality is vitally important. It can help you understand why you make the decisions you do, how you are likely to react to the deep-rooted uncertainty in investing, and how you can control the illogical elements of your investment decisions.
We hope this series of posts has highlighted some of the psychological traps in investing that most people are susceptible to. Thinking about these in the light of your own financial personality will hopefully help you avoid them.
This information is taken from our free report Beyond Greed and Fear, to download a copy please just click here.
As always, if you have any questions or thoughts on the points covered in this post, please leave a comment below or connect with us @ISACO_ on Twitter.
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ISACO are a specialist in ISA and SIPP investment and together with our clients have an estimated £75 million actively invested1. To help investors like you, we offer a high end service called ‘Shadow Investment’. Put simply, we invest and you invest beside us. As we grow our wealth, you grow yours.
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1 Internal estimation taken January 1st 2015 of total ISA and pension assets owned by the ISACO Investment Team and ISACO premium clients.2 December 31st 1997 - December 31st 2014 ISACO 105.5%, FTSE 100 27.6%.
3 December 31st 2011 – December 31st 2014.
ISACO investment performance verified by Independent Executives Ltd.
