Many people have too much confidence in their own abilities.
In one piece of famous research, for example, 93% of Americans claimed to be better-than-average drivers1. It doesn’t take a lot to realise that this is a mathematical impossibility.
What has been shown to be true in relation to driving can be applied to other walks of life. Thinking we are better drivers than we really are can have dangerous consequences. Equally, overconfidence when investing can be dangerous for our wealth.
Imagine you are an investor who has just had a successful run of picking winning shares or funds. You may conclude that this success is down to your investment skill. That may be the case. But it’s also possibly the result of luck.
The problem is, if you believe you only have your skills to thank, you will likely try to repeat your success and even take greater risks in the future. While this could lead to greater profits, it’s just as likely to result in greater losses. Is the risk really worth it?
How overconfidence can cost you
Research has shown that overconfident investors not only take on more risk but also tend to trade more frequently, with a subsequent reduction in their returns. Over a six-year period, Professors Barber and Odean carried out research on over 78,000 US share trading accounts, analysing over three million trades. Specifically, they wanted to understand how investment returns differed for the 20% of investors who traded the most compared with the 20% who traded the least.
The results are enlightening. The confident, frequent traders achieved annual returns of 11.4% compared with 18.5% for the less active traders2. To put this into perspective, £1,000 invested at the beginning of the period would have grown to more than £2,700 after six years for the active traders, compared with more than £4,000 for the infrequent traders.
Interestingly, the professors also found that the women in the study traded less frequently than the men and consequently had better returns.
Strategies to keep overconfidence in check
The real problem, especially when it comes to investing, is that the more overconfident we are, the less likely we are to see it. So the next time you are about to trade, pause and ask yourself:
- Are you in fact likely to know better than the market?
- Would this trade be in line with your long-term financial plan and investment strategy?
It can also be helpful to play devil’s advocate by coming up with uncertainties or reasons that your trade might be a bad choice. Making it a habit to question your assumptions is a powerful way to combat overconfidence.
1 Ola Svenson, “Are we less risky and more skilful that our fellow drivers?” Acta Psychologica, 1981.
2 Barber and Odean, “The courage of misguided convictions”. Financial Analysts Journal, 1999.
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