Statistically speaking, most people are overconfident. That’s not just a catchy opening line, it’s scientific fact. What’s more, overconfidence is often at its worst in complex tasks. Since that includes investing, investors and advisors should take heed.
Whether investors are picking stocks, deciding on a general investment strategy or wondering if an advisor has the chops to get the job done, the science of overconfidence has solid lessons.
We spoke about the research with Dr. Erik Angner, behavioral economist at George Mason University and author of A Course in Behavioral Economics.
People Are Generally Overconfident, and Investors Are No Exception
Our intel on overconfidence comes from research by Dr. Erik Angner of George Mason University
According to a large body of scientific research, people are generally overconfident. And nothing suggests investors are immune.
“A generation’s worth of research suggests that overconfidence is endemic among amateurs and professionals,” says Angner. “That’s true in both everyday decisions and highly technical, professional contexts. It affects scientists and doctors, investors and politicians. The evidence at this stage is sizable.”
So what does this mean for investors? Investing with too much confidence can cause serious problems. That’s true both for individual investors who follow their own advice and for those who use advisors. Overconfidence leads to poor decisions, risking too much and placing too much value on what might just be a guess.
People in general can guard against overconfidence by following a few safeguards. Most of these involve knowing there’s a problem and then falling back on solid data.
Are You Calibrated Properly?
When it comes to confidence, a mind is perfectly calibrated if whenever it is 80% confident, it actually is right 80% of the time, and so on for every level of
confidence. If someone claims 90% confidence but is only right half the time, there’s something wrong. Unfortunately, this situation is anything but hypothetical.
How does that relate to investing? Investors and advisors fall prey to overconfidence as much as ordinary folk. In fact, there’s evidence that complex tasks such as investing carry high degrees of overconfidence.
That’s bad, because being too sure of your decision making ability can lead to poor decisions that ultimately cost big money. Fortunately, there are definite red flags that point out overconfidence in ourselves and experts like advisors. The good news is, there are also clear steps to keep from making costly ego-based mistakes.
Overconfidence Isn’t Always Bad
Just because someone is overconfident, that doesn’t make them incompetent. An overconfident investor or advisor may not necessarily be making lots of bad decisions.
“Overconfidence isn’t the only thing you want to look at in yourself and in an advisor,” says Angner. “It’s possible for someone to be better at predicting what’s going to happen, better at distinguishing good investments from bad, and at the same time to be overconfident. So if I’m totally clueless and I know it, I may not be overconfident but I’m also not the person you would trust with your money.”
In other words, an advisor who’s right 80% of the time but thinks they’re right 90% may still be a safer bet than someone who’s only right half the time and knows it.
The trick is to know which one you’re dealing with. Are you overconfident? Underconfident? Just right? Is your advisor overconfident? The answer to that question is incredibly important. It can mean the difference between a green light to invest without fear or a stop sign that saves you from big losses. We list seven ways to protect yourself from overconfidence below.
1. Don’t Confuse Confidence With Competence
Whether in investing or the world at large, the first step to battling overconfidence is to keep confidence and competence apart. In the investment world, an investor can become convinced they’re more successful than they are just by how they feel. It can also mean investors unduly trust advisors who talk the talk.
“People have a tendency to confuse confidence with competence,” says Angner. “If a professional is super confident then you might mistakenly infer that this person really knows what he or she is talking about. I actually have an example of that myself. I had a minor skin condition at some point and I went to a dermatologist and he was diagnosing me while looking out the window. I was thinking, man, this guy has got to be a really good doctor. He can diagnose me without even looking. It’s interesting that even though I’ve worked on this, I attributed to him extreme competence simply because he had expressed himself so confidently.”
2. Know the Confidence Level
Another step to fighting overconfidence is to assess the confidence level. That’s important because high confidence without data is a red flag for overconfidence.
The science suggests that the more certain someone is, the more likely they are to be a poor judge of their own ability. That doesn’t necessarily mean an investment advisor who pounds his or her chest about extremely high success rates is lying.
“There’s some chance that the advisor is lying to you,” says Angner. “But more likely and more interestingly, there’s something called a hindsight bias that makes us think in retrospect that we were much better than we really were. Your advisor may be no better than chance. That doesn’t mean that he or she doesn’t honestly, sincerely think that he or she is much better than that. So just asking your advisor for an honest assessment is not going to be enough if you really want to know how often they’re wrong.”
The fix is to know that:
- Extremely high confidence is probably inflated.
- Real performance data are the only accurate way to judge success.
3. Know the Track Record
Another step to guard against overconfidence in general and in the investment world is to know the person’s track record.
“Just telling yourself you might be overconfident is not going to make any difference. What you really need is evidence to the effect that you’re wrong 30% of the time or 50% of the time. That’s why you need feedback, so you can’t trick yourself into thinking that you’re better than you are.”
People who measure their performance are less likely to fall prey to overconfidence.
“One of the things that does seem to make a difference,” Angner says, “is having feedback that’s prompt and unambiguous. Feedback that allows you to judge whether you were right or wrong in the past. One thing you can try to do, both as an investor and when you’re shopping around for an advisor is to try to figure out what the track record is and how often people were right in the past. Then compare that to the level of confidence in yourself or in your advisor.”
For an investor, that means measuring performance. How high is your true success rate? How many times are you right vs wrong? When dealing with advisors, the key is to ask whether they measure their performance and if so, whether they can show proof.
4. No Clear Track Record is a Warning Sign
If someone doesn’t keep deep data on their track record, that doesn’t mean they are necessarily overconfident. But, someone who doesn’t have data on their past performance is at risk for falling victim to false certainty.
If you ask an advisor for their track record and they can show a detailed feedback system, that’s evidence they’re measuring performance. It also means the advisor is working actively against becoming overconfident.
“A football kicker is an example of someone with an excellent degree of feedback,” Angner says. “A kicker knows immediately whether they’ve performed well or not. That feedback helps them to improve their own performance.”
Medical doctors on the other hand often don’t get good feedback. They prescribe and refer, but even if they haven’t fixed the problem they may never see the patient again. The patient may move on to a specialist or seek a second opinion. The condition may resolve on its own. In those cases, the doctor may never learn whether their decision solved the problem.
“It’s the same with investments,” says Angner. “We tend to remember things went better than we thought. Some people don’t even want to know how good their performance was. In politics, a skewed opinion of past performance is almost essential.”
An Investment Feedback Tool
Personal Capital makes an online tool investors can use to get good feedback on how their investments are performing. Investors can link multiple accounts and track overall performance and success rates in real time. Real performance can also be tracked in graphs and compared to stock indexes at large.
5. Beware of “Everybody Knows”
Steer clear of decisions based on common wisdom. In the investment world, this may mean not following the herd. It may also mean taking advisors who cite common knowledge with a grain of salt.
Groupthink is the idea that decisions made in groups tend to gloss over valid criticism. Hordes of economic lemmings can stampede us off financial cliffs. In the buildup to the 2001 financial crisis, “everybody knew” investments in dot com companies were gold. Before 2008, “everybody” knew the safe money was in real estate.
When asked what his biggest concern was about being shot into space, Neil Armstrong famously answered, “Well, I think we tried very hard not to be overconfident, because when you get overconfident, that’s when something snaps up and bites you.”
6. Diversify, and Set it and Forget It
Finally, Angner says, “Be aware of the fact that you might be
Diversify
Diversification in an investment portfolio means spreading investments across stocks, bonds, cash and other investments like real estate. Of course the idea is that if some investments crash, others will rise.
Set it and Forget It
The standard investment advice of “set it and forget it” is another way to stave off overconfidence. Rather than follow the advice of stock-picking experts, the smart money gets put into a good mix of investments and left there. The exception is if the money will be needed in the next few years.
Source:
Economists as Experts by Erik Angner