We recently held a webinar relating to behavioural finance and if we’re honest with ourselves one of the behavioural biases that most of us can relate to would be overconfidence. Psychology has found that humans tend to have unwarranted confidence in our decision-making – we have an inflated view of our own abilities.
This behavioural trait appears to be universal in most aspects of our lives. If you are asked the question, “Are you more attractive than the average person?”, almost no one says no! Studies show that when a group is asked this type of question, about 75% believe they are above average. It doesn’t matter if the question relates to our looks, our athletic ability, or our intelligence – most of us believe we are above average. Interestingly, most people think they will save 1.8 times more than the average person!
In Jason Zweig’s book “Your Money & Your Brain”, he highlights a study of 50 drivers who were asked to rate their “skill, ability and alertness” the last time they were behind the wheel. Approximately 65% said they were at least as competent as usual. Many described themselves as “extra good” or “100%”. What makes this even more interesting is that the study was performed in hospital – the drivers started their trip in their own car and ended in an ambulance!
The answers are even more astounding when you read that the police reports found that 68% were directly responsible for their crashes, 58% had at least 2 past traffic offences, 56% totalled their cars and 44% would face criminal charges! Only 10% admitted that they were partially responsible for the crash.
One of the difficulties with investment decisions is that they are complex, are not made frequently and involve forecasts of the future. Overconfident investors tend to overestimate their ability to pick investments and estimate future performance. They overestimate their performance relative to others. Overconfident investors will also take their past success, which is often due to luck or some other external factor, and assume it was their skill. Mistaking skill for luck further increases their overconfidence. Studies show that overconfidence investors trade more frequently and fail to diversify their portfolios because they, erroneously, know where the best opportunities lie.
So how do you act rationally when your perfectly natural human instincts might be working against you? US investment firm Charles Schwab provides some investing principles that can help:
Play devil’s advocate: Make the case against your own decisions and then ask yourself if you really want to move ahead.
Seek a second opinion: Outside perspectives from financial consultants or other trusted sources can help you build a case for an investment decision or spot potential red flags.
Set goals: Don’t worry about how other people are investing their money-you’re not competing with anyone. Instead, focus on building a portfolio that will help you achieve your own financial goals. You just need to have a plan to help get where you want to go, when you want to get there.
Diversify: A robust, diversified portfolio can reduce the effects of being wrong on a single trade. This may also apply for people with a large chunk of company stock. No matter how confident you are in the company’s performance, don’t bet your future on it.
