Overconfidence causes people to overestimate their knowledge, underestimate risks, and exaggerate their ability to control events.
Are you a better driver than average? If you answered yes, based on your self-evaluation, your response is typical. Most of us think we are better drivers than the average person we share the roads with. Unfortunately, that doesn’t leave many people to fill in the rest of the graph . . . i.e., in the average and below average ranges.
In everyday life, when we have to make countless decisions quickly and often based on little information, overconfidence is a robust character trait. We’ve all noticed that underconfident drivers can create dangerous situations when they make decisions too slowly or are too timid.
However, this tendency to overestimate our abilities and our accuracy of judgement isn’t confined to driving. In 2006 researcher James Montier asked a similar question of 300 professional fund managers. Guess what? 74% of them believed that they were performing above-average, and the remaining 26% thought they were average performers.
That’s not just poor math, it’s an indication that overconfidence might be leading these fund managers to make decisions that are not optimal. Individual investors are susceptible to the same human trait of overconfidence but have access to less information about their investments, and are presumably less skilled, than professionals. This puts them even more at risk of making investing mistakes.
Dr. John Nofsinger, who specializes in the relatively new field of behavioural finance, wrote that overconfidence causes people to overestimate their knowledge, underestimate risks, and exaggerate their ability to control events. Overconfidence is highest when the gap between accuracy and confidence is the greatest: overconfidence diminishes as accuracy increases from 50 to 80 percent, after which people become underconfident. In other words, people are most confident when they have the least knowledge. He points out that the gap between accuracy and confidence is not related to intelligence.
The result is that investors may make decisions without recognizing they do not have enough information. If the results are positive, they are inclined to attribute their success to their skill and judgement rather than luck. Conversely, poor results are chalked up to bad luck or unfortunate timing. Too much confidence in their skills leads investors to trade too often, resulting in erosion of the value of their portfolios through fees, taxes and missed opportunities for growth. Professor Hersh Shefrin, author of Beyond Greed and Fear (2000), found that individuals who traded the most fared the worst, underperforming the index by 500 basis points. (Similarly, a 2011 study reported in the International Journal of Business and Management, Overconfidence and Excessive Trading Behavior: An Experimental Study, provided empirical evidence supporting the theory that excessive trading related to highly overconfident behavior leads to poor investment performance.)
And, sorry men, we seem to be more prone to the downsides of overconfident investing than women. Brad Barber in his 2001 study, Boys Will Be Boys: Gender, Overconfidence and Common Stock Investment (Journal of Economics) found that men tend to trade 45% more than women. This trading reduced the returns of male investors by 2.65 percentage points per year, as compared to 1.72 percentage points for women. Over time, 1% makes a huge difference in your returns.
Because overconfidence leads us to underestimate risk, as investors we tend to take on too much risk in building a portfolio. We place too much money in a single investment or any single group of investments. We try to time the market by buying into and selling out of stocks, when research shows that picking winning investments is very difficult, even for professional investors. Overconfidence can also cause us to fail to act—or to react too slowly—to new information.
What can we do to curb our tendency to be overconfident as investors? Well, simply becoming aware that this trait is likely influencing our decision-making process is the first step. That awareness will lead us to take corrective action as part of our investment process, through seeking rational and logical supporting evidence for the decisions we make. Creating an investment plan which takes into consideration where we are now and where we wish to be at some point in the future will take the impulsiveness out of the process. We can apply scientific principles and research to our expected outcomes. We can build a diversified portfolio. And we can find a qualified advisor to help us stick to our plan, through good times and bad. If you can find a trustworthy advisor who will hold you accountable to your dreams and plans for the future, that person will earn every penny you pay them and more.
As the nineteenth century American humourist Josh Billings said: It’s not what a man don’t know that makes him a fool, but what he does know that ain’t so.
This article by Daryn Form was published in the October 2012 edition of Sask Business Magazine.
Daryn Form is a Senior Financial Advisor with Assante Capital Management Ltd. providing wealth management services to principals of family-owned and privately held companies. Assante Capital Management Ltd. is a member of the Canadian Investor Protection Fund and is registered with the Investment Industry Regulatory Organization of Canada. The information mentioned in this article is for general information only. Please contact him to discuss your particular circumstances prior to acting on the information above. The opinions expressed are those of the author and not necessarily those of Assante Capital Management Ltd. Rates are not guaranteed and are subject to change at any time without notice.