Why Overconfidence Can Hurt Investors

"The most difficult subjects can be explained to the most slow-witted man if he has not formed any idea of them already; but the simplest thing cannot be made clear to the most intelligent man if he is firmly persuaded that he knows already, without a shadow of a doubt, what is laid before him." — Leo Tolstoy, 1897

Yes, you can have too much of a good thing. For investors, that "thing" can sometimes be confidence. Though it seems counterintuitive, too much confidence can work against investment success, limiting our potential returns in various ways.

Overconfidence can give the illusion of control. It can lead us to: trade too frequently; invest in riskier assets that may not be right for us; try to time the market; and convince ourselves that our financial acumen and returns are stronger than they are.

Overconfidence is rife in all spheres of life. Do you know anyone who considers themselves a better-than-average driver, better than average at getting along with people, or a better investor than they really are?

In the late 1980s, psychologists at the University of Pennsylvania launched a long-term study, inviting nearly 300 experts in politics, economics, intelligence analysis and journalism to predict the probability of various events within their areas of specialization. The group made more than 25,000 predictions. It turned out that, on average, they were hardly more accurate than random guessing would have been. Some experts were 80 per cent sure about their predictions, yet they were proven right less than 60 per cent of the time. The conclusion: we can become enamoured with our own opinions.

Overconfidence Pitfalls

Numerous studies have shown that investors can fall into the overconfidence trap. A key study by Terrance Odean at the University of California, Berkeley reviewed the trading patterns of 10,000 accounts at a large discount brokerage firm to see whether the securities the investors purchased outperformed those they sold by enough to cover the costs of trading. He found that overconfident investors (measured by comparing self-assessments of skill to test outcomes) were prone to over-trading, and on average, the securities they bought underperformed the ones they sold.

In a large study undertaken in 2012 by the Center for Applied Research, an independent think tank, individual investors were asked about their financial know-how. Nearly two-thirds said their financial sophistication was "advanced." Two years later, the centre conducted another study, in which participants completed a financial-literacy test. The average score was just 61 per cent.

Does all of this mean we are doomed to fall prey to the overconfidence bias? Of course not. But there are several effective strategies that can help identify and manage overconfidence.

Look for a contrarian view: To avoid making decisions within an echo chamber of overconfidence, you could seek out a devil's advocate for an opposing view. By discussing your respective positions, you'll both gain more clarity on why and how you arrived at your conclusions.

Develop an investment approach: A checklist can help ensure that a prospective buy or sell is a rational, not impulsive, decision. Your checklist can include: major financial goals; time horizons; tolerances for risk, volatility and losses; investment constraints (e.g., maybe it's avoidance of "sin stocks" — generally considered tobacco, alcohol or gambling); core asset allocation (percentage of assets in equities, bonds, cash or real estate); and a rebalancing schedule.

Keep an investing journal: You might consider tracking your decisions in an online or old-school journal so you can easily review how they worked out.

Expand your knowledge: Financial literacy can fuel investing success. The more knowledge you gain about investing, the better you'll understand the options available to you.

Be humble: Even investing titans constantly question their choices and review financial literature to ensure their decisions are supported by current research.

Have you ever been bitten by overconfidence when it comes to investing? Leave a comment to share your experiences.