Why the overconfidence bias can cost investors

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Your investment ego may be costing you a lot of money.

The “overconfidence bias” is the behavioral principle of overestimating one’s own abilities, including financial acumen. And while confidence isn’t a bad thing, it can have detrimental results if you don’t have the skills to back it up.

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“It should come as no surprise that for the average investor, overconfidence could potentially be a pathway to poor portfolio performance.” wrote Omar Aguilar, CEO and chief investment officer of Charles Schwab Asset Management.

For example, this “ego-driven bias” could trick your brain into thinking it’s possible to consistently beat the stock market with risky bets, Aguilar said. Statistics show that it is difficult for professionalsso it will be difficult for the average person as well.

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Beyond adding potentially unnecessary risk to a portfolio, an investor’s overconfidence could lead to higher relative costs associated with frequent buying and selling of assets, Aguilar said.

a recent report from the Financial Industry Regulatory Authority, or FINRA, shows that many investors may have this bias.

Nearly 2 in 3 investors, 64%, rate their investment knowledge highly and 42% are comfortable making investment decisions, according to FINRA. Younger investors, ages 18-34, were more likely to be confident than those in the older age groups: 35-54 and 55+.

However, more confident investors also answered disproportionately more incorrect questions on a FINRA investment questionnaire, suggesting that “many younger investors are not simply uninformed, but potentially misinformed,” according to the report.

Investors rarely receive financial feedback

Knowing how sure you should or shouldn’t be is known as “calibration.” People are generally well calibrated if they receive frequent feedback on decisions, letting them know if they were right or wrong in direction, said Dan Egan, vice president of behavioral finance and investing at Betterment.

The problem is that people don’t often get that feedback in financial settings, Egan said.

“It’s very easy to get the impression, ‘Actually, I know a lot and I haven’t been proven wrong,'” Egan said. “And we’re not going to look for it.”

“We tend to protect our egos,” he added. “We want to think well of ourselves.”

Technology and social media have also made it easy for people to develop false impressions of their own knowledge and ability, Egan said. For example, investors may fall victim to “confirmation bias,” whereby they look to social media circles for evidence that confirms a previously held but potentially false belief.

Of course, technology and the Internet have also made it easier than ever to access information, although users must discern whether that data source is accurate and reliable.

And while younger investors may disproportionately overestimate their knowledge, it’s unclear how much it’s hurting them, Egan said. They may not have amassed a lot of money this early in their careers, which means a mistake may be less expensive compared to older people, who amassed considerable savings during their working lives and have more to lose.

When an investment is hot, ‘start watching yourself’

The overconfidence bias in investing tends to manifest itself most often with get-rich-quick investment decisions, Egan said.

“That’s when you need to start looking at yourself,” he said.

take the meme stock bonanza or the cryptocurrency fever in 2021, for example. Millions of investors brokerage accounts created beginning of the year for the most part capitalize in an increase in prices; if they entered or sold at the wrong time, there could have been cost them Bucks.

Similarly, overconfidence can lead hasty investors to accidentally buy the wrong stocks, Egan said.

For example, many investors bought Signal Advance shares in 2021 following a tweet from Elon Musk, who told followers to “use Signal,” sending the stock higher. by more than 400% in one day. However, investors inadvertently bought the wrong shares: The CEO of Tesla and SpaceX was referring to the encrypted messaging app Signal, while Signal Advance is a maker of small components.

How to control your investor ego

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One way to overcome potential overconfidence is to examine past investment decisions and how they worked, Aguilar said. Take a look at how overconfidence may have led to poor results over time and what a more realistic approach could have accomplished, she said.

Also, investors can use a “pre-mortem” strategy, Aguilar said.

The concept, invented by psychologist Gary Klein and endorsed by proponents like Nobel Prize-winning economist Daniel Kahneman, tries to overcome overconfidence by imagining potential outcomes from a future perspective. The purpose is to improve a decision rather than have it “autopsied” after the fact, Klein said. wrote.

Imagine, perhaps one, five, 10 or 20 years from now, that your investment was a success. Think about the reasons for that potential success. Also, imagine it was a disaster and think about the reasons why, Aguilar said. The exercise can help people see “potential risks and missteps” that they overlooked due to excessive optimism, Aguilar said.

“Being aware of the mistake, I think, is definitely worth it,” Kahneman has said. saying of the strategy

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