Think you’re smarter than average? Whilst this is mathematically true for only around half the population, we think most people would likely answer ‘yes.’ Regardless of whether you happen to be smarter than average, this sort of statistical impossibility is one example of people generally overestimating their abilities and skills—also known as overconfidence. Confidence can be a good thing but, in investing, overconfidence can lead to critical errors that may seriously hurt your chances at a comfortable retirement. Here we’ll explore where this bias comes from, some of the other cognitive errors that often accompany it, and why it can be one of the biggest factors standing between investors and their goals.
The Origins of Overconfidence
Overconfidence likely stems from behaviours that provided humans an advantage in the past. In hunter-gatherer societies, overconfidence may have been an evolutionary necessity—when the average work day involves chasing down an animal five times your size for dinner, it’s hard to be too confident. But modern life and investing are very different, and giving in to overconfidence these days can warp our investing habits for the worse.
Unfortunately, many other human tendencies contribute to overconfidence, making it a potentially powerful bias that’s difficult to overcome. For instance, we may naturally accumulate pride about our skills and accomplishments. In investing, pride accumulation occurs when investors attribute investing successes to what they believe are their skills, potentially ignoring the true underlying reasons (or even luck) that may have been involved. On the other side of that coin is regret shunning, which occurs when investors attribute their investing failures to outside forces instead of acknowledging personal mistakes and limitations.
Confirmation bias is another natural inclination that can feed into overconfidence and further wreak havoc on our decisions. Confirmation bias leads us to only pay attention to evidence that supports our pre-existing beliefs. We can see this in many aspects of life. Unless you love to argue, you probably spend more time with people who generally share your beliefs than with people who contradict your ideas at every opportunity. Similarly, most of us tune in to news sources that generally express our political beliefs. When investing, if you limit yourself to information that validates your existing beliefs, you’re essentially creating blind spots in your strategy. Markets are complex and dynamic. If you narrow your focus too much, you’re increasing the likelihood you miss something important that may impact your investments.
Another common error, hindsight bias, is also closely tied to pride accumulation and regret shunning. Hindsight bias is the feeling of ‘I knew it all along!’—even if that wasn’t the case. We have a tendency to remember the more prescient thoughts we had in advance of an eventual event and disregard the conflicting thoughts we had at the same time. For example, leading up to the 2008 global financial crisis, do you remember feeling a financial downturn was imminent? Were you concerned about the real estate market in the United States and subprime mortgages, and expected those concerns would impact equity markets? Now, if you did have these concerns, did you act on them? We’ve encountered many investors who say the downturn was obvious at the time, but still participated in the declines—classic hindsight bias. Inaccurately remembering past judgments like this can lead us to overestimate our future ability.
The Consequences of Overconfidence
Overconfidence—in conjunction with confirmation bias, hindsight bias and other cognitive errors—can lead to many poor investing choices that can significantly impact your financial future. Overconfident investors may overestimate their investment-picking ability, which can lead to making big bets and taking big risks.
For instance, have you ever bought into a ‘hot’ initial public offering or a potentially risky security because you remember past securities you ‘knew’ would do well before they surged? Was your choice based on careful, thorough, impartial analysis? Because hindsight could be a factor, and if that leads you to make a big, risky investment, you could be taking on more risk than you should due to bias.
Owning too few equities is another potentially damaging strategy to which overconfident investors may fall victim. If you own just a handful of individual equities in your portfolio, you’re likely making large, risky bets. Investing in equities always carries the risk of loss—no matter your confidence level. However, you can lower your individual security risk by diversifying your portfolio with at least a few dozen equities from various industries and geographies. An extreme case of this error occurs when investors hold their own employer’s shares as a large portion of their investment portfolio. You may think you work for a great company, but virtually no one but the most senior executives truly knows the direction of the company, and sometimes even they don’t know an equity-tanking scandal is about to unfold.
Consider the case of Enron employees in the 2000s—those who invested in Enron’s shares in their retirement plans not only lost their jobs when the company folded, but also lost their retirement savings. Workers for Parmalat in Italy or Swissair in Switzerland may have encountered similar situations if they decided to hold large investments in their company’s shares prior to the company’s equity losing its value.
How can you avoid making these mistakes? Given all the various ways investors can fall prey to overconfidence, it may seem overwhelming. But you can take several steps to help stay humble and prudent when investing.
To begin, flip your natural tendencies on their heads by shunning pride and accumulating regret. You can always be wrong in your investing choices—even the most legendary investors don’t get it right all of the time. In fact, if you were right just 70% of the time over the long term, you would likely be an investing legend. Look for opportunities to recognise your mistakes and take responsibility for them. Revel in them a while. Learn from them. And remember, not all of your past investing successes can be attributed to your own skill—luck is often a factor. For proof, consider keeping a journal of your investing thoughts and comparing how often they actually aligned with market performance. Revisit it often—how frequently were your thoughts or predictions actually aligned with real market movement? If you made a market decision, check to see if it made you worse or better off. Even if you did well, did you actually outperform relative to other similar investments? If you are able to learn from the times you were mistaken, you may have a better chance of avoiding similar mistakes in the future.
You can also consider using a trusted financial adviser or coach to help you stay on the path towards your goals. Avoiding common investing mistakes can be difficult, especially when working on your own. An adviser may be able to help provide an impartial perspective and investing expertise. Finally, study markets as much as possible. But be wary as you gather your information and don’t forget the impact of confirmation bias. Do your best to seek out multiple sources of information, including those that may present opposing beliefs or viewpoints from your own.
Although you can never be fully rid of biases, you can be more aware of them and know how to minimise their impacts on your investing decisions. Whilst behavioural biases apply to many aspects of life, making financial mistakes because of them can have far-reaching consequences. They may actually hinder your ability to retire or live the comfortable retirement you’ve been working towards. So don’t forget to check your biases at the door when you start investing—and continue to re-evaluate them every day.
Fisher Asset Management, LLC does business under this name in Ontario and Newfoundland & Labrador. In all other provinces, Fisher Asset Management, LLC does business as Fisher Investments Canada and as Fisher Investments.
Investing in stock markets involves the risk of loss and there is no guarantee that all or any capital invested will be repaid. Past performance is no guarantee of future returns. International currency fluctuations may result in a higher or lower investment return. This document constitutes the general views of Fisher Investments Canada and should not be regarded as personalized investment or tax advice or as a representation of its performance or that of its clients. No assurances are made that Fisher Investments Canada will continue to hold these views, which may change at any time based on new information, analysis or reconsideration. In addition, no assurances are made regarding the accuracy of any forecast made herein. Not all past forecasts have been, nor future forecasts will be, as accurate as any contained herein
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