Most of us believe we are better at some things than we really are—whether we’re conscious of it or not. Psychologists call this phenomenon “overconfidence,” and it’s a common human tendency that creeps up in all aspects of our lives. When it comes to investing, however, overconfidence manifests itself in at least three distinct ways:
- First, we tend to overestimate our ability to select investments and evaluate their performance.
- Second, we overrate our performance relative to that of others.
- Third, we are prone to overprecision, or being excessively certain about the accuracy of our predictions and instincts.
Overconfidence can put investors at a disadvantage because it encourages them to trust their own knowledge over outside sources that could help them make better decisions. Overconfident investors also tend to trade too much, and the cost of trading combined with poor performance from bad trades can compound over time.1
There’s nothing wrong with being confident—indeed, trusting our own abilities often leads to better outcomes—but overconfidence can be a hindrance. Fortunately, there are tried-and-true investing principles that can help curb overconfidence:
- 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.
- Diversify: A robust, diversified portfolio reduces the effects of being wrong on a single trade.
- 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.
1 Hersh Shefrin, Beyond Greed and Fear: Understanding Behavioral Finance and the Psychology of Investing, Oxford University Press, 2002.