Fighting Investors' Greatest Enemy: Overconfidence

"I always thought the brain was the most wonderful organ in my body; and then one day it occurred to me, 'Wait a minute, who's telling me that?'" -- Emo Philips

Financial analytics firm Dalbar calculates the actual returns earned by investors compared with the S&P 500. Its latest reading is cringeworthy: The average stock investor earned an average annual return of 3.83% from 1990 to 2010, vs. 9.14% for the S&P 500.

That gap is more than can be explained by management fees or the underperformance delivered by the average mutual fund's poor skills. Something else is eroding investment returns.

And that something else is you.

You buy when you shouldn't. You sell when you shouldn't. You think you're capable of doing things you probably aren't. You are, in other words, overconfident in your skills as an investor.

You've probably heard of the Lake Woebegon effect with drivers -- the vast majority of drivers claim they have above-average driving skills. This even holds true for drivers surveyed in the hospital after being injured in car accidents that they caused.

The same overconfidence affects investors.

Markus Glaser of Munich School of Management and Martin Weber of the University of Manheim once asked a group of investors a simple question: How have you done at investing?

Just like drivers, more than half assumed they outperformed the average investor.

But the study found something even more disturbing. The researchers asked investors to estimate their annual returns, and then compared those estimates to the investors' actual returns by checking their brokerage statements. Investors were quite literally clueless about how their investments performed, overestimating their returns by more than 11 percentage points per year. The average investor painfully lags an index fund and thinks he's Warren Buffett, basically.

Part of this is understandable. Investing is hard. We spend untold hours talking with advisors, researching new ideas, watching CNBC, and listening to pundits. Most investors have uncomfortably little to show for their effort, so they resort to convincing themselves otherwise. Jason Zweig writes in his book Your Money and Your Brain:

By fibbing ourselves, we can give a needed boost to our self-esteem. After all, none of us is perfect, and daily life brings us into constant collision with our own incompetence and inadequacies. If we did not ignore most of that negative feedback -- and counteract it by creating what psychologists call "positive illusions" -- our self-esteem would go through the floor.

We're also overconfident because hindsight bias fools us into thinking big events like the financial crisis were easy to predict, and thus will be easy to predict in the future. In his book Thinking, Fast and Slow, Daniel Kahneman writes:

Our tendency to construct and believe coherent narratives of the past makes it difficult for us to accept the limits of our forecasting ability. The illusion that we understand the past fosters overconfidence in our ability to predict the future.

When you are overconfident, all sorts of dangerous behaviors arise that throw your investing results off track.

For one, your predictions will likely become less accurate. Philip Tetlock, a psychologist at U.C. Berkeley, studied expert predictions and found that those who were most confident in their forecasts actually had the worst track records. Confident forecasters tend to have broad, unwavering views about how the world works -- think of investors who were assured hyperinflation was right around the corner -- while those who make good predictions know that the world is more nuanced and are constantly updating their views.

As confidence rises, your perception of risk also diminishes. The best example of this is the hedge fund Long Term Capital Management, a team of investors stacked with PhDs and Nobel laureates who became so confident in their ability to predict markets that they borrowed $250 for every $1 of their investors' money ... and went broke soon after. Financial advisor Carl Richards says, "risk is what's left over when you think you've thought of everything else." When you're overconfident, you're not thinking about much to begin with.

Overcoming overconfidence is easier said than done. But two things might help.

One, become fiercely objective when measuring your success as an investor. Don't just assume you've done well because the Dow is at an all-time high and your portfolio has gone up, too. Measure exactly how you've done. Most investors will be surprised to see their returns versus a benchmark -- some pleasantly, others humbled off the ledge of overconfidence.

Two, talk to someone about your investments who is in a different emotional state than you are. The odds of making a good decision while in the heat of panic, euphoria, or any other emotion tied to overconfidence are low. I run most of my financial decisions by fellow Fool Matt Koppenheffer. He thinks differently than I do and is more level-headed in areas I tend to get emotional about. It's a tremendous benefit, and I encourage everyone to find a "finance buddy" with whom to do the same.

Every investor needs confidence. But Mae West wasn't right: Too much of a good thing isn't always wonderful.

Check back every Tuesday and Friday for Morgan Housel's columns on finance and economics. 


Read/Post Comments (25) | Recommend This Article (33)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On July 16, 2013, at 12:52 PM, jpanspac wrote:

    Good article, as usual, but if I'm not mistaken you've written very similar articles 2 or 3 times already.

  • Report this Comment On July 16, 2013, at 12:56 PM, TMFHousel wrote:

    A lot of what I write is a new twist or combination of something I've written in the past, yes. I'll quote Jason Zweig:

    "I was once asked, at a journalism conference, how I defined my job. I said: My job is to write the exact same thing between 50 and 100 times a year in such a way that neither my editors nor my readers will ever think I am repeating myself.

    That’s because good advice rarely changes, while markets change constantly. The temptation to pander is almost irresistible. And while people need good advice, what they want is advice that sounds good."

    I sometimes repeat myself because I think it's preferable to giving bad -- but new -- advice that sounds good.

  • Report this Comment On July 16, 2013, at 1:03 PM, TMFHousel wrote:

    And for what it's worth, I've written 2,600 articles and I believe this is the only one dedicated to overconfidence.

  • Report this Comment On July 16, 2013, at 2:23 PM, valari25 wrote:

    That may be true Mr. Housel, but the message is the same. And thank you so much for that. I've managed to get a few of my coworkers to start investing for their retirement and your articles are what I tell them to read first to keep them following their plan when the markets get crazy and they want to panic. I may even use them myself, if I weren't so good at investing all on my own....

  • Report this Comment On July 16, 2013, at 2:31 PM, SkepikI wrote:

    OK Morgan, you get both the humility and forbearance award for the week by resisting pointing out despite repetition, there are still plenty of folks who both need and don't that advice....

  • Report this Comment On July 16, 2013, at 2:33 PM, SkepikI wrote:

    "don't TAKE that advice" too fast with snide commentary. ;-)

  • Report this Comment On July 16, 2013, at 2:34 PM, TMFHousel wrote:

    ^ There's part of that, too. I write about the same stuff because people keep making the same mistakes.

  • Report this Comment On July 16, 2013, at 2:37 PM, TMFHousel wrote:

    I should say: *we* keep making the same mistakes. I fall for the same mistakes I write about.

  • Report this Comment On July 16, 2013, at 3:22 PM, ShrikeTheFoolish wrote:

    Another good one, thanks Morgan. Any thoughts about writing a book? Something to rival the Rule Makers / Rule Breaker books of so long ago.

  • Report this Comment On July 16, 2013, at 3:24 PM, TMFHousel wrote:
  • Report this Comment On July 16, 2013, at 5:46 PM, SMFT wrote:

    Morgan, will you be my "investment sounding-board buddy"?

    :-)

    Yikes, but I was surprised a few months ago when I looked at my performance vs. S&P500 over the past 10 years. I didn't under-perform by much, but I was so convinced that I had out-performed before I Iooked. It was, indeed, humbling, but, it also convinced me to move some holdings into several S&P index-funds - which have done pretty well since Mid-March......

    It's always nice to be knocked-down a notch. Reminds you of your limitations.....

  • Report this Comment On July 16, 2013, at 11:15 PM, mrudolph72 wrote:

    Please everyone keep in mind that there are always new investors finding these articles. Just because someone has seen a similar piece a few times doesn't mean everyone has.

    I've only been actively investing about 3 years. I've made every mistake in the book already except for ever thinking I'm a good investor. I have tracked my results and have steadily been disappointed compared to benchmarks.

    I even bought $300 of a penny stock once because I knew it was about to take off. Luckily it was only $300 dollars. It's worth about $120 now. I'll keep it forever or until it goes bankrupt as a reminder that I'm not as smart as I think I am.

    In fairness to myself I have identified some quality investments but I don't have the patience, temperament, or confidence to see them through hard times. Indexing and rebalancing was good for me in the past and should be in the future. You all who can buy individual stocks and do well are a rare breed.

    Thanks for another quality article and best of luck to everyone.

  • Report this Comment On July 17, 2013, at 10:42 AM, reidmr wrote:

    I am the epitome of a neophyte to this game. So overconfidence isn't a problem (yet). I've read Kahneman's book and several articles on this exceptionally helpful website. Articles such as this lead me to believe that most investors essentially run in place - a lot of research, a lot of scrambling to buy and sell, a lot of stress, only to achieve earnings at or below the S&P rate. So why not just buy index funds and call it a day? What's the catch - your timeframe?

  • Report this Comment On July 17, 2013, at 10:50 AM, rmhjah wrote:

    I think TMF posts so many articles about the mental state of investors because mental state is such an important aspect of investing. I've come across only a few ideas that cannot be explained using simple algebra and I work as a physicist.

  • Report this Comment On July 17, 2013, at 11:06 AM, BeckonsAttore wrote:

    Hm. I disagree. How about over-ignorance? It seems to be a much bigger problem over seas that it is in real lie. Just saying. Especially the China. ?And stillsiswe h ff

  • Report this Comment On July 17, 2013, at 12:11 PM, miteycasey wrote:

    Investors were quite literally clueless about how their investments performed, overestimating their returns by more than 11% per year."

    Over estimating there returns by 11% is bad? Seriously? That's roughly .5% to 1% in actually numbers. 5.5% v. 5% and 11% v. 10%.

    That's pretty close.

    That's like saying how many miles did you drive last year and you guessed 20,000, but you only drove 17,800. Many people round up when guessing saying 'about' or 'close to'.

    Another 'bad' statistic.

  • Report this Comment On July 17, 2013, at 12:53 PM, hardy wrote:

    So TMF, where's the tool that lets us track our actual performance versus the relevant indexes? And I don't just mean the S&P500 either, and dividends must be included...

    I use a very simple tool: I snapshot the value of my portfolio occasionally, along with SPY and a basket of low-cost ETFs representing the distribution of investments I have. I then add the dividends to the return of the SPY and the basket of low cost ETFs, and compare to my portfolio net worth. If I'm not exceeding either, I try to go find out why.

    What I need is this tracking to be done on every stock. That will help me find out why. The software can't be that hard...

  • Report this Comment On July 17, 2013, at 1:59 PM, cooncreekcrawler wrote:

    Good job, Morgan. The longer I invest, the less sure of myself I become, the more skeptical I become, the more cautious I become, and slowly, but surely, the more money I am making because I have realized that there is really no hurry. If I lose a perceived good deal, there will be others in time---always time. Or to say it another way, if I feel I've GOT to do something today, there is something driving me other than reason---usually greed.

  • Report this Comment On July 17, 2013, at 2:03 PM, jordanwi wrote:

    @hardy - google finance.

  • Report this Comment On July 18, 2013, at 10:49 AM, Chontichajim wrote:

    If I need to tell what my annual return has been I will always go to my statements before venturing a guess, so I don't see how anyone can be off on that subject. Another measure of effectiveness may be to measure buying trends with PE levels. If people buy more when PEs are relatively high then that is bad, but I don't see that documented. When a person invests for income (dividend) they may know full well they are not going to beat the S&P but do that deliberately to bank the dividends.

    What I can see over the past few years is a lot of activity in 2011 (volatile markets), modest activity in 2012 (two good buying seasons), and almost nothing in 2013 (straight up market good for holding but not buying).

    For accounts I don't spend much time on (grandchildren) just stick with a set of balanced ETFs and forget about it until they are 18 and blow it on high priced cars.

  • Report this Comment On July 18, 2013, at 9:34 PM, BordLyron wrote:

    Another good one. To pick a nit: it's <I>effect</I>', not <I>affect</I>.

    Byron

    (Unsure if the HTML will work - no preview & entering this stuff on an ipad (my first try) is bloody awkward.)

  • Report this Comment On July 19, 2013, at 4:30 PM, PeoplesInvestor wrote:

    Great Article Morgan,

    There is this great story, that after a Roman Triumph a slave would whisper in the commander's ear, as he was paraded through the streets, "you are only a man."

    I wonder if Charlie Munger does that for Buffet?

  • Report this Comment On July 20, 2013, at 7:02 AM, TMFDukenewkirk wrote:

    Miteycasey, I believe Morgan meant when the average investor's annual return came in at 3.8 %, they would guess it was 14.8% (really, they'd say "oh, about 15%) not even realizing how truly remarkable that actually is compounded year over year. I'm pretty confident that's what the study's point must have been.

    Hardy, if you have a membership with any premium service at the Motley Fool, you have access to a scorecard that measures each of your purchases against the s&p. This is handier than my basic online brokerage service ($5/trade I'm not complaining) which only tracks current holdings. The Fool Scorecard has all of my last 8 years of purchases tracked this way. I know exactly how I've performed vs the s&p at all times and now averaged over 8 years.

    Oh and the many wise Fools I've met on the boards and have known for years, the community for each holding, together make up my sounding boards.

    Another worthy article the newbies will always value especially, and there's new newbies every day. So by all means do dress it up and say it again.

  • Report this Comment On July 20, 2013, at 10:04 PM, portefeuille wrote:

    Don't blame me, I gave you the proper trend line for the S&P 500 index -> https://pbs.twimg.com/media/BPqZaDECEAAYWr3.png:large more than 4 years ago :)

    see this post -> http://caps.fool.com/Blogs/chart-yeay/825502.

    https://twitter.com/portefeuillefun.

  • Report this Comment On July 21, 2013, at 5:38 PM, TMFHousel wrote:

    <<will you be my "investment sounding-board buddy"?>>

    Always open for a chat. Mhousel@gmail.com

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