A lack of financial confidence could stop you investing – but overconfidence can be far more dangerous. You risk losing money, writes Sheryl Sutherland.
If you ask people if their driving ability is average, above-average or below-average in comparison to other drivers, they’re likely to answer above-average.
Some 82 per cent of students in a recent survey rated themselves in the top 20 per cent of their group.
Statistically, however, the results should have been one-third above-average, one-third average and one-third below average.
It’s common to overestimate your ability – and when that affects your investing decisions, it can be dangerous.
Psychologists have discovered that we tend to overestimate our level of financial knowledge, underestimate risk and exaggerate our ability to control events.
Although both sexes show overconfidence, men are generally more overconfident than women.
One researcher studied more than 150,000 trading accounts and found that women sold an average of 53 per cent of the shares they held each year, while men traded a much higher 77 per cent a year.
Do you know what you don’t know?
Today we have quick and unparalleled access to vast quantities of data on the internet. When we estimate our level of knowledge, we tend to confirm our existing beliefs by searching for data which supports our views – and skimming over information that doesn’t.
We buy products and services because we believe the more knowledge we have, the more accurate our forecasts will be. But does this lead to better quality decisions? If a little knowledge is a dangerous thing, what’s a lot of knowledge?
Behavioural scientists have come up with the term ‘calibrated confidence’, which means knowing what you can and can’t do.
It’s about being comfortable with knowing how limited your abilities really are.
A lack of confidence in your own ability to do something usually results in a lack of activity. In investing, that’s actually a good thing, because low activity levels have been proven to produce better outcomes.
The odds are like Lotto
As a financial adviser, if I had a dollar for all the stories I’ve been told by overconfident investors, I’d be very rich indeed.
Their overconfidence usually relates to fantastic returns from everything from property, to bitcoin, to the tech bubble.
Most overconfident investors fall into a money illusion called ‘ignoring the base rate’.
This is a tendency to disregard or discount the overall odds in a situation. It makes you prone to exaggerating their ability to control events.
Look at these events and see if you’re surprised by how unlikely they are.
What are the odds?
· Winning Powerball Division One on a Power Dip: 1 in 3,070,704.
· Dying from slipping or tripping: 1 in 6,548.
· Suffering an unprovoked shark attack: 1 in 6,000,000.
· That you’ll keep buying and not win the jackpot after 50 years: 149 in 150 (99.33 per cent).
· Winning Lotto Division One on a Lucky Dip: 1 in 373,838.
Are you overconfident?
If you see yourself in several of these statements, you may be overconfident.
- You think you’re beating the market consistently.
- You claim credit for profits, but explain away the losses.
- You make investments or spend without much research, or you have numerous financial information sources.
- You trade frequently.
- You don’t know the return on your investments.
- You think you should invest in ‘what you know’.
- You think investing without an adviser is smart and easy.
- You’re willing to take large risks.
- You invest heavily in one market sector.
- You disregard indicators that don’t endorse your position.
- You’re willing to ride losses.
- Your ‘let’s take a chance’ attitude increases.
- You believe that the best is yet to come.
First published 20 July, 2018
This article is part of the Rational Investor series by Sheryl Sutherland. Sutherland, of the Financial Strategies Group, is an investment adviser who has worked in the industry for the past 30 years. She’s also the author of multiple best-selling books.
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JUNO does not contain financial advice as defined by the Financial Advisers Act 2008. Consult a suitably qualified financial adviser before making investment decisions. This story reflects the views of the contributor only. Content comes from sources that JUNO considers accurate, but we do not guarantee that the content is accurate.