The concept of behavioral finance is a relatively new field of study that combines psychological theory with conventional economics. We may not realize it, but we all have certain biases as investors, and that impacts the financial decisions we each make. Even the most disciplined investor may have difficulty overcoming personal biases – it’s how we’re wired!
In our Financial Bias series, we’ve explored some of the most common behavioral biases to which people find themselves susceptible, and how they could be holding us back. Today we look at how overconfidence can affect our investment decisions.
There’s nothing wrong with being confident, but overconfidence can lead to a tendency to overestimate what we know or what we’re capable of. It’s why people often underestimate traffic. Or overestimate how much they can fit into a day.
While believing you can always beat traffic or the clock likely won’t have dire consequences, overconfidence can sabotage your decisions when it comes to more important and complex matters. That’s why taking steps to counteract it can help keep you maintain just the right amount of confidence when it comes to achieving your goals.
Overconfident investors frequently believe they can time the market, despite the high rate of failure for those who try. And overconfident investors tend to believe their success with a particular strategy or kind of investment can be repeated. Believing their picks are sure to perform well, they might concentrate their portfolios in just a few holdings, even though a wealth of evidence shows that a diversified, well-rounded portfolio has performed better over time.
When it comes to financial planning, overconfidence tends to create the illusion that past success was the result of intrinsic skill, leaving little room for the role of external forces or plain luck. An overconfident individual might assume their income will only go up, underestimating the possibility of losing a job or becoming incapacitated and needing long-term care.
Overconfidence is one of the surest ways to undermine the success of a long-term financial plan. Fortunately, it doesn’t have to be the downfall of yours. You can overcome overconfidence by:
- Taking an objective look at past successes. How much was you? How much was due to external circumstance? How much was luck?
- Ensuring that your long-term plan can handle the unexpected – like a sudden health event, longer-than-predicted retirement, or market shift.
- Considering the real source of your gut feelings. Is your confidence greater than the evidence to support? Does data or external research back you up?
- Taking an honest look at the fee and tax consequences of your investment activity. How much time and money do you spend to trade very actively? Do the gains outweigh those costs on a consistent basis?
- Seeking out the perspectives of people whose beliefs differ from your own and professionals with specialized expertise. In the case of your financial future, it helps to work with an objective third party – like your advisor – who can offer perspective in addition to financial planning and investment management.