The Overconfidence Conversation

Overconfidence is a very serious problem, but you probably think it doesn't affect you. That's the tricky thing with overconfidence: The people who are most overconfident are the ones least likely to recognize it. We tend to think of it as someone else's problem.

When it comes to investing, however, we all have a problem.

As we become more and more confident, we become willing to take on more and more risk. Why? We start seeing risky behavior as, well, less risky. But in reality, as the level of overconfidence increases, the cost of our mistakes increase as well.

The classic example is Long Term Capital Management. A hedge fund run by some extremely smart people (Nobel Prize winners, in fact) ended up losing $3 billion in 1998 and was bailed out by a group led by the New York Fed. The geniuses at Long Term were positive that the most they could ever lose in a single day was $35 million. Then on Aug. 21, 1998, they lost $553 million.

Consider more recent events. For years, Alan Greenspan, chairman of the Federal Reserve for 19 years, could do no wrong. His overconfidence was supported by four presidents. Greenspan's faith in his models contributed (some say it caused) the worst market crash since the Great Depression. In October 2008, Greenspan admitted to Congress that he was "shocked" when the model he had used confidently for over 40 years turned out to be "flawed."

This is a big issue. It affects Nobel Prize winners, Fed chairmen, and individual investors as we make allocation decisions in our 401(k) plans.

But we can do something about it. We need to recognize that we're not as smart as we think we are. In fact, the smartest investors (and, frankly, the smartest financial advisors) are the ones who acknowledge that they're dumb.

So the next time you're about to make an investment decision because you know you're right, take the time to have what I call the Overconfidence Conversation. Find a friend, spouse, partner, or anyone you trust and walk them through your answers to the following questions:

  1. If I make this change and I'm right, what impact will it have on my life?
  2. If I make this change and I'm wrong, what impact will it have on my life?

Considering the consequences of being wrong might lead you to make more careful decisions and to a greater appreciation of the enormous potential costs.

A version of this post appeared previously in The New York Times.

Carl Richards is a financial planner and the director of investor education for the BAM ALLIANCE, a community of more than 130 independent wealth management firms throughout the United States. Visit Behavior Gap for more of Carl's sketches and writings.

The Motley Fool has a disclosure policy.

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  • Report this Comment On January 17, 2013, at 3:23 PM, basohn wrote:

    I fear everyone is over confident in this market. I am looking at the hard numbers of unemployment, lower wages, lower hours worked, ever higher personal, institutional, & especially government debt, and the mind blowing government spending, ridiculously low unsustainable interest rates, ever higher gas and food prices, over all flat housing prices, which all indicate to me we get less income and our income gets us less, yet the market still grows. I am baffled? What am I missing? I honestly don't get it. To me all the fundamentals of a strong economy are absent, but the Market is up higher an higher. Am I the only one that feels this way? Are not all these signs the same ones that accompanied the housing bubble burst? I would genuinely appreciate feed back.

    Thank you.

  • Report this Comment On January 17, 2013, at 3:37 PM, FooLawson wrote:

    Good point, but also don't forget as investors we see emerging trends before they are known by the public, not saying the public won't ever know they just don't look. look at the hard numbers, consistent years, etc. you will see, we have what looks to me like a cycle.

    But finding the right investment must be foreseen.

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