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