Overconfidence | Behavioral Finance

Behavioral Finance | Overconfidence

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You’ve got this. Or do you?

Overconfidence. It’s why people often underestimate traffic. Or overestimate how much they can fit into a day. It’s also what’s led people to strike out when trying to strike it rich throughout history.

But what does it mean for you?

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What is overconfidence?

In simple terms, overconfidence is our tendency to overestimate what we know or what we’re capable of.

It usually trips us up in small ways, creating not a belief that we’re exceptional at everything, but instead giving us blind spots about individual traits, like how quickly we can complete a list of chores or how our navigational skills compare to a GPS.

Overconfidence has been the subject of extensive scholarly scrutiny, studies and surveys. Like one that found that 93% of Americans believe they are above average drivers.1 And another from Harvard that found students believed they could predict daily egg production in the U.S. with 98% accuracy, but were only accurate 60% of the time.

Overconfidence = Underperformance?

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.

It’s why overconfident investors frequently believe they can time the market, despite the high rate of failure for those who try. Price movements are notoriously unpredictable, and guessing wrong even a few times can significantly impact returns. For example, from 1997 to 2016, missing just 10 of the market’s best days would cut an investor’s return nearly in half compared to someone who stayed invested the whole time.2

It’s also why 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 overconcentrate their portfolios even though a wealth of evidence shows that a diversified, well-rounded portfolio has performed better over time.

Often, overconfidence is the driving force behind the irrational exuberance that precipitates – or creates – a market crash. An overconfident CEO might be likelier to relax a financial institution’s lending standards and make it more vulnerable to the shock of a crisis.3 And, on a smaller scale, 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.

When overconfidence creeps into your financial plan:
  • You might take past successes – due to luck or external factors – to mean that you’ll be successful with future choices.
  • You might eat away any gains with high transaction costs and taxes from regular buying and selling.
  • You might be underdiversified because you prefer to focus on individual stocks or certain kinds of securities.
  • You might miss or ignore signals and external advice that suggest making a change.

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.

How you can overcome overconfidence

  1. 1. Take a more objective look at past successes. How much was you? How much was due to external circumstance? How much was luck?
  2. 2. Ensure your long-term plan can handle the unexpected – like a sudden health event, longer-than-predicted retirement, or market shift.
  3. 3. Consider the real source of your gut feelings. Is your confidence greater than the evidence to support? Does data or external research back you up?
  4. 4. Take a good 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?
  5. 5. Look for help. Seek 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 an experienced financial advisor – who can offer perspective in addition to wealth planning and investment support.

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 just the right amount of confident when it comes to achieving your goals

25% of those age 45+ are not at all prepared financially for sudden long-term care costs.5
While 69% of young investors surveyed gave themselves high marks for financial know-how, only 8% actually demonstrated high-level financial knowledge.6

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