By: Joseph V. Goldy, AAMS®
In my last article, I touched on how the behavioral challenge of loss aversion can be detrimental to investors. By causing people to resist making intelligent strategic moves in their portfolio out of fear of recognizing a loss, the result may be investment underperformance over the long run. Today we are going to briefly look at another common behavioral challenge investors face, namely overconfidence.
What is Optimism Bias
Overconfidence affects all of us from time to time in many areas of our lives, but can be particularly damaging to investment portfolio performance. With respect to investing, overconfidence, or optimism bias as it is sometimes referred, manifests in people making decisions that not only will potentially cause underperformance versus relevant benchmarks but more importantly, may result in taking more risk for investors at a time in their investing lives when doing so is contradictory to what they should be doing based on their age and financial goals. People do this because they have an unrealistic view of their skill level in a particular area causing their subjective view to be skewed.
To see how overconfidence unfolds in the investment world, it helps to take a step back and observe how human beings generally have a favorable view of themselves and their ability to control a situation, even when that may not be the case. Whether it be our judgment on when to buy or sell an investment, athletic prowess, leadership skills, or any other area, we tend to view our own abilities in a very complimentary light.
For example, anyone who has watched the popular television show America’s Got Talent has witnessed overconfidence playing out in a real world scenario. By and large, everyone that appears on the show is quite confident that they are talented enough to win. Yet, many are not that talented, or at least not to the degree they believed. When the judges deliver the bad news that they will not be moving on to the next round, their subsequent reactions of shock and disbelief are an example of someone’s overconfidence bubble bursting in real-time (which coincidentally also makes for entertaining television). They have an optimism bias in their own ability and when an outside force (the panel of judges) comes along to recalibrate their reality, it often does not go well.
How Over Confidence Can Lead to Investment Mistakes
False Sense of Understanding
More specific to investing, two of the biggest dangers people face is when overconfidence causes a false sense of understanding about investments of which they may not be knowledgeable about. Or, when investors simply disregard the need for proper risk management.
For instance, as can be seen with the bull market that began in 2009 and just ended this year, investors are realizing investments such as oil funds, leveraged exchange traded funds, and real estate investment trusts, carry risks that may not have been fully realized while the market continued to move higher each year.
Aside from sustaining losses due to potentially not being diversified enough for their specific risk level, the deeper issue is that investors tend to look for other reasons behind their losses so as not to bruise their egos. For instance, losses attributable to a lack of knowledge about an investment can now be easily blamed on the pandemic we are currently experiencing rather than a lack of due diligence on the part of the investor prior to investing in a particular vehicle.
Disregard for Risk Management Strategies
Perhaps even more detrimental to an investor’s success in achieving his or her financial goals is the disregard for a true risk management strategy that optimism bias can cause. Often when I talk with clients who have been self-directing their investments I observe behavior such as an over-concentration in just a few stocks, frequent trading, borrowing on margin, and speculating with options.
During a bull market, all of these can have fleeting moments of success. Yet, when the market hits a rough patch, which it will at some point, all of these investment strategies are often a recipe for underperformance, or worse, severe losses.
The underlying problem for many investors venturing into uncharted waters is a function of not having put together an investment plan to follow first. When time is taken to create a realistic financial plan, crafted around a person’s life’s goals, their ability and willingness to take risk, and an honest reflection about what to expect from their investments, they are significantly more inclined to stick with their strategy through good markets and bad.
The desire to stray into the fringe of the investment world looking for unrealistic returns is minimized as they are equipped with the knowledge that it is not necessary to take on excess risk to achieve what they really want in life.
As human beings, we are all vulnerable to behavioral biases and overconfidence is something we will experience at various moments throughout our lives. Most of the time, it may be as harmless as simply realizing that you are not as indispensable at work as you may have thought (think Jerry Maguire).
However, when it comes to investing, it can be seriously harmful to achieving your financial goals. Being able to work with your investment professional to create a plan and remain objective during bull and bear markets is key to avoiding this common pitfall and the harm it can inflict on your investment performance.
Learn more about Highland Financial Advisors’ Investment Approach, or schedule an appointment to speak with an advisor.
Author Bio
Joseph Goldy, CFP®, is a wealth advisor and CERTIFIED FINANCIAL PLANNER™ at Highland Financial Advisors, LLC, a fee-only fiduciary wealth advisory firm based in Wayne, New Jersey.
Joe specializes in working with newly independent women because of divorce or losing a spouse. He understands firsthand the value of having a clear financial picture pre- and post-divorce and a plan to restate goals as a single person. When he is not helping clients, Joe enjoys spending time with his two sons outdoors and volunteering to help raise money for Type 1 diabetes organizations.