FINANCIAL PITFALLS ... OVERCONFIDENCE

I have written regularly about the importance of information (to be able to make informed decisions); and some of the more common barriers to making sound choices. Notable among these roadblocks are misinformation, fear, greed, pride, and desperation. Today, I want to write about a commonly overlooked pitfall - overconfidence ...

One of the most common biases researchers have documented is our natural tendency to be overconfident about beliefs and abilities as well as overoptimistic about our assessments of the future. One illustration I always find humorous is where large groups of participants are questioned about their competence as auto drivers [in relation to the average driver in the group as well as to everyone who drives a car]. Obviously driving a car is a risky activity and skill plays an important role. In the case of college students, 80 to 90% believed they were more skillful, safer drivers than others in the class. In another experiment involving students, people were asked about likely future outcomes for themselves and their roommates. They typically had very idealistic views about their own futures (i.e., successful careers, good health, happy marriages, etc.). When asked to speculate about their roommates' futures, their responses were far different ... they were far more likely to become alcoholics, suffer illnesses, get divorced, and a plethora of other unfavorable outcomes. Different studies reveal similar phenomena (when asked to rank how well people get along with others, 100% of respondents ranked themselves in the top half of the population; 25% believed that they were in the top 1% of the population). I think you get my point.

Many researchers have argued that this tendency to be overconfident is particularly strong among investors. More than most other groups, investors tend to exaggerate their own skill and deny the role of chance. They overestimate their own knowledge, underestimate the risks involved, and exaggerate their ability to control events. Research conducted (by Odean & Barber) found that the more individual investors traded, the worse the return/performance [and male investors traded much more than women, with correspondingly poorer results]. Many potential explanations exist for this "illusion" of financial skill; having a selective memory of success is a likely culprit in many instances. In hindsight, it is easy to convince yourself that you knew Google was going to be a great investment. People are prone to attribute any good outcome to their own abilities and rationalize away bad outcomes as resulting from unusual external events (outside of our control).

Just some food for thought as you make your daily financial decisions ...