Confidence can be an admirable trait—but overconfidence can hurt you.
Researchers have revealed a variety of ways in which overconfidence can lead us astray in our investing lives. And the consequences—ranging from lost returns and poorly timed trading to insufficient saving for retirement—can be very costly.
Here we’ll dig into some of the common features of overconfidence and provide some tips investors can use to manage the problem.
Elements of overconfidence
Psychologists have repeatedly shown how people tend to overestimate the quality of their knowledge, particularly when it comes to making predictions about the future. In an interesting paradox, overconfidence seems to thrive in foggy situations. Doctors, lawyers, and other professionals who work in complex, uncertain environments have all been shown to fall prey to overconfidence.1
The world of investing is an almost custom-made proving ground for these psych lab observations. For example, it’s extremely difficult to reliably predict which stocks might beat the broader market over time, but people still try to do it.
Overconfidence manifests itself in at least three ways among investors:
- First, we tend to overestimate our ability to pick investments and estimate future performance. Particularly when you’re familiar with a company, whether because you work for it or are devoted to its products, you may feel unwarranted confidence about its stock—leading to overconcentration or insufficient diversification.
- Second, we overrate our performance relative to that of others. For example, we might assume we’re simply better at analyzing publicly available information than other people.
- Third, we are prone to overprecision, or being excessively certain about the accuracy of our predictions and instincts. This can happen because we think have better information, or are working off a theory or model that appears to bolster a hunch, or are perhaps more focused on the things that could go right than we are the things that could go wrong.
How can this hurt you? In a number of ways. And because the consequences of a bad move might only become clear over time, it’s not always easy to correct course.
Insufficient retirement planning. The Employee Benefit Research Institute (EBRI) talks to workers and retirees every year to see how workers’ expectations for retirement stack up against the experience of people actually living in retirement. In the latest survey,2 the EBRI found that although workers are less confident now than they have been in recent years, roughly 60% of them still said they were confident they’d be able to save enough to afford a comfortable retirement, including 18% who said they were very confident. In contrast, only 41% said they'd ever tried to calculate how much money they'd need to save for a comfortable retirement.
Unsupported confidence like this could lead to surprises down the line. For example, almost half of the surveyed retirees said their healthcare costs were higher than expected, and just over a third said their non-healthcare expenses were higher than expected. If you think you’ll work through retirement to help cover costs, consider that less than 30% of those surveyed were actually employed—even though almost 80% expected to be.
Excessive trading. Researchers have found that overconfident traders trade more often than more rational traders.3 Trading commissions and frequent round trips around the bid/ask spread—or the difference between what buyers are willing to pay for a stock and what sellers are willing to accept to sell it— end up consuming a large chunk of the most active traders’ returns.4 One study concluded that on average households that traded frequently generated annualized returns that were seven percentage points lower than households that traded less frequently.5
Overconfident, overly active traders also appear to time their trades poorly: They sell stocks that have gone on to outperform the stocks they’ve bought.6 Overconfident investors also appear to trade even when the expected returns are lower than their trading costs.
What you can do
The first thing to keep in mind is that even if you are really confident in your abilities, the smartest investor doesn’t always win. To quote Warren Buffet: "You don't need to be a rocket scientist. Investing is not a game where the guy with the 160 IQ beats the guy with a 130 IQ. Rationality is essential."
How do you achieve rationality when your perfectly human instincts might be working against you? Here are some investing principles that can help:
- Play devil’s advocate: Make the case against your own decisions and then ask yourself if you really want to move ahead.
- Seek a second opinion: Outside perspectives from financial consultants or other trusted sources can help you build a case for an investment decision or spot potential red flags.
- Set goals: Don’t worry about how other people are investing their money. Instead, focus on building a portfolio that will help you achieve your own financial goals. You don’t have to beat the market. You just need to have a plan to help get where you want to go, when you want to get there.
- Diversify: A robust, diversified portfolio can reduce the effects of being wrong on a single trade. This may also apply for people with a large chunk of company stock. No matter how confident you are in the company’s performance, don’t bet your future on it.
1 Brad Barber and Terrance Odean, “Boys Will Be Boys: Gender, Overconfidence and Common Stock Investment,” The Quarterly Journal of Economics, 2/2001.
2 Employee Benefit Research Institute, “The 2017 Retirement Confidence Survey: Many Workers Lack Retirement Confidence and Feel Stressed About Retirement Preparations,” 3/27/2017.
3 Brad Barber and Terrance Odean, "The Courage of Misguided Convictions," Financial Analysts Journal, Nov.-Dec. 1999.
4 Brad Barber and Terrance Odean, “Trading Is Hazardous to Your Wealth: The Common Stock Investment Performance of Individual Investors,” The Journal of Finance, 4/2000.
6 Terrence Odean, "Do Investors Trade too Much?" The American Economic Review, 12/1999.
What you can do next
- Listen to more episodes of Choiceology, a podcast about the psychological traps that lead to expensive mistakes.
- Do you trade frequently? Enroll in Schwab Trading Services and review your trading plan with a Schwab trading specialist.
- Need help planning for retirement? Consider Schwab Intelligent Portfolios PremiumTM, our unique approach that combines professional advice with automated investing.