Confidence is a funny thing.> Those who deserve it tend to lack it. Those who least warrant it are often overencumbered by it. And getting it can be your downfall. So just how prone are we to overconfidence? And what does it mean for our performance as investors?
Overconfidence, of course, is hardly limited to investing and education and experience don t seem to make us immune. Research released this year found that lawyers are terrible at estimating the prospects of their clients (they re too optimistic). Other research has shown that doctors treating terminal patients consistently and substantially overestimate the time their patients have left to live.
Investment pros fall into similar traps. A study by researcher James Montier found that professional fund managers overwhelmingly live in Lake Wobegon: In a sample of nearly 300 managers, 74% were sure they were above average at their jobs. Given that, year after year, most actively managed funds don t beat the market, there must be something screwy going on inside these managers heads.
But individual investors aren t any saner. In fact, a recent study of Taiwan s stock market found that individual investors are more likely than their institutional counterparts to trade aggressively in a bull market or when their forecasts pan out.
What causes amateurs to mistake themselves for Warren Buffett when they re probably closer to Jimmy? One famous investigation of this phenomenon, by Brad Barber of the University of California, Davis, and Terrance Odean of the University of California, Berkeley, looked at the behavior of investors in the 1990s, just as many were jumping into online trading. These were heady times, when suburban dads dreamed of quitting their jobs at the flannel-shirt factory with the fortunes they d make day-trading Pets.com.
But the online migration apparently turned pretty good investors into overconfident (and bad) investors. These investors went from beating the market by 2% annually to lagging by more than 3% annually, trading more actively and more speculatively than before.
Barber and Odean cite several factors behind this change: Most notably, the investors attributed their successes to their own skill and believed they had more control over their stocks performance than they really did. Researchers have seen those same factors in other endeavors: We always like to credit our successes to skill while dismissing failures as bad luck. We believe we can control anything, even the roll of a pair of dice, when it s our hand doing the rolling. Mix in confirmation bias the tendency to, among other things, overremember our successes and investing can create an overconfidence perfect storm.
Clearly, overconfidence has its uses. Who would start a business without a rosy assessment of the odds of success? But when it comes to keeping confidence and realism in balance, the key is self-knowledge. Think you re outsmarting the crowd? Remember that everyone else in the crowd thinks the same thing and then think again. After all, it s awfully hard to distinguish between overconfidence and regular confidence. Confident you can tell the difference? That probably means you re overconfident.