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Sit Down, Be Humble: Overconfidence & Investing

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We humans are notorious for overestimating our abilities. We're a cocky bunch. Let's take a look at how big our heads really are and its influence on our finances.

Apparently, We're All Above Average

A 1977 study found that 90% of college professors believed they had above average teaching abilities. With two-thirds believing they were in the top quartile.

A 1981 study found that 80%-90% of college students ranked their driving abilities as above average.

 A 2000 study found that 87% of Stanford MBA candidates believed their academic performance was above average.

So, we're all above average?

Obviously that can't be the case. Math doesn't work that way! These are examples of illusory superiority, the tendency for us to irrationally overestimate our abilities.

There are many more studies like these; demonstrating how we think we're more athletic, more beautiful, and have more potential than the "average person".

Overconfidence and Investing 

Overconfidence runs rampant in investing. We all think we're smarter, have better information, and are more skilled than the rest.

"Buy Telsa, trust me, you'll be rich."

 "The recession is coming, trust me, we're due, sell everything!"  

Nobody can predict the future. Thinking you can will just lead to poor decisions. People overly confident in their stock picking ability will fail to diversify properly. People who think they can time the market will end up sitting on cash, missing gains while they wait for a recession to come.

The cockiest among us tend to trade more, raking up unnecessary fees and exposing themselves to costly mistakes. A 2000 study examined thousands of accounts over a 5 year period and found that the more investors traded, the worse their performance. The most active traders earned an annual return of 11.4%, at a time when the market returned 17.9%. Not great.

 But I Do Really Well, I Swear! 

You might have had some success, sure. Even a broken clock is right twice a day. Given how unpredictable and competitive markets are, these fortunate events were most likely a result of luck rather than skill.

Investors have selective memories and irrational interpretations of outcomes. Remembering (and bragging about) the wins and conveniently overlooking losses (unless you're r/wallstreetbets). We tend to attribute wins as a display of skill, while losses as freak accidents.

We also suffer from hindsight bias. In hindsight, it's easy to convince ourselves that we knew the housing market would sky rocket and that Facebook would rise 400%. Hindsight bias contributes to overconfidence by making us think investing is more predictable and controllable than it really is.

Conclusion

It's easy to fall into the overconfidence trap. The key is to take a step back when assessing your skills and outcomes. Analyze with these biases in mind, question assumptions, and ask for second opinions. Doing this, you'll be able to dampen your inherit overconfidence to make more rational decisions. Stay humble out there.









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