Behavioral Finance: Overconfidence
In theory, financial markets are efficient. All necessary information is available to the public and logical decisions can be made by rational, unemotional investors. However, theory and reality are often quite different, and investing is no exception.
The study of investor behavior is called Behavioral Finance. For more information on the basics, see our post “Behavioral Finance: Intro”. Research shows that people are not nearly as rational when making investment decisions as traditional finance theory suggests. Our decision-making is influenced by our own psychological biases.
What is “Overconfidence”?
The balance between too much confidence and not enough is a very fine line. Some areas of life see confidence, even overconfidence, as a strength. Others, like investing, view it as a weakness. Overconfidence bias is a tendency to hold a false and misleading assessment of skills, intellect, or talent; people believe they are better than they actually are.
Here are a few examples to help illustrate this definition:
- When American’s were asked to judge their own driving abilities, 93% claimed to be above average
- A survey of 1 million high school students showed 70% think they are above average leaders (only 2% rates themselves below average)
- 94% of college professors believed their research was above the average of their peers
With the average being 50%, the three examples above are statistically impossible. If you were asked to rate your driving on a scale of 1-10, what would you choose? “Overconfidence has been called the most ‘pervasive and potentially catastrophic’ of all the cognitive biases to which human beings fall victim. It has been blamed for lawsuits, strikes, wars, and stock market bubbles and crashes.”
How Overconfidence Can Impact Your Portfolio
As it relates to finance and investing, there are a few common types of Overconfidence that continue to show up:
- Over ranking: When an investor rates their personal performance as higher, or better, than it actually is. While most people believe they are better than the average, we know that to be statistically impossible. Over ranking typically leads to taking on too much risk.
- Illusion of Control: When an investor thinks they have control over a situation when, in reality, they do not. Similar to over ranking, this tends to lead to excess risk in a portfolio. By falsely believing they have control, the investor assumes they can successfully navigate the risks or that potential risk is lessened.
- Desirability Effect: When an investor overestimates the odds of something happening because it has a desirable outcome. For example, believing there is a greater probability of Investment A increasing more than Investment B simply because the investor owns Investment A, but not Investment B.
Looking at mutual fund managers specifically, a survey asked 300 professional fund managers to self-assess their investing abilities. 74% thought they were above average. The remaining 26% marked themselves as average. With 100% of fund managers thinking they are average to above-average, 50% of them are statistically wrong. “I know everyone thinks they’re above average, but I really am.”
The Value of a Professional Advisor
It is important to understand the connection between your investments and the long-term goals of your financial plan. One of the primary benefits of working with a professional advisor such as PDS Planning is our ability to provide discipline and guidance to manage our innate psychological biases. According to research by Vanguard, “Behavioral coaching may add 1% to 2% in net return”. As they explain, “Having emotions isn’t a “rational or irrational investor issue; it’s a human issue.” While most investors have the best intentions when making financial decisions, in the heat of the moment when emotions are elevated, they may have a hard time sticking to their plan.
Since 1985, PDS Planning has worked with clients to eliminate the stress often associated with planning your financial future. With over 30 years of experience helping clients plan their investments, we’re experts at optimizing an investment plan to each individual’s highly specific needs. We’ll work to understand your vision for the short and long-term. And we will provide objective guidance on the proper path to help reach your goals.
To learn more about PDS Planning, please contact us.
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