When people think that they are greater, stronger, smarter, or luckier than normal, they misperceive reality and make poor decisions. For example, the vast majority of the population believes that they are above average when it comes to their driving ability, getting along with others, and having a sense of humor. But how could that be? The “average” represents the middle ground, so how can most folks be better than the average?
Telling yourself what you want to hear
One common cause of overconfidence is the comfort you derive from telling yourself what you want to hear.
If you buy a stock that goes up, you may say, “I knew it was ready to jump.” If the investment drops, you might rationalize your decision by saying, “I might have gotten the timing a little off, but I’ll just hold on and it will recover.”
Professor Dan Ariely of psychology and behavioral economics at Duke University explains, “We tell ourselves stories [about what is going on in the stock market] that try to explain what happens. And even though we’re just telling a story about a random pattern, all of a sudden we start believing in it. And because we believe in it, we believe in our ability to explain the stock market. … We say, ‘Look at me. I really understand what is going on.’ But it’s not really understanding. It’s just that you can tell yourself a story after the fact.” This story cushions the frustration that you may otherwise feel if you admit to yourself that you might not know as much about investing as you thought you did.
Too much information?
Overconfident investors think that they know exactly what they are doing and absolutely understand how the market works. Today, there are many finance and investing sites on the web, and it is easy to think that by reading all of this readily available information you are now sufficiently knowledgeable about the markets to trade very actively.
However, this leads to what behavioral psychologists refer to as “the illusion of knowledge.” In various studies, groups of informed investors were found to have an increased sense of confidence to forecast the market, which didn’t keep pace with the accuracy of their predictions. One effect of “the illusion of knowledge” is that it can make you think you don’t need to seek any further advice when making financial decisions, which can ultimately work against you, and cause you to lose money.
How can you avoid overconfidence in investing?
Though you need a certain amount of confidence for a healthy self-image, you also need to understand your limits. Don’t assume you can predict the future of the stock market, and don’t hire an investment advisor based on his self-assured appearance alone. Ask questions and inquire about his practice and how he can hopefully increase your bottom line.
When making investment decisions, understand that while it’s good to be well informed, it’s always important to consult with a competent, objective financial advisor to gain a rational, logical perspective. It’s good to believe in yourself, but if you know your own limitations, it’s even better.
How confident are you? Take this overconfidence test to find out!
Douglas Goldstein, co-author of Rich As A King: How the Wisdom of Chess Can Make You A Grandmaster of Investing, is an avid chess fan, international investment advisor and Certified Financial Planner (CFP®).