ONE SPRING DAY in 1995, McArthur Wheeler walked into two banks near his Pittsburgh home and robbed them at gunpoint.
His plan had one critical flaw: The disguise he chose didn’t hide his face at all. Instead of the usual stocking cap or hat and sunglasses, Wheeler made an unconventional choice. He applied a coating of lemon juice to his face. His reasoning: Lemon juice could be used to make invisible ink, so Wheeler figured it would have the same effect on his face, making it invisible to surveillance cameras.
Because he was so easily identified, Wheeler was arrested just hours later. As police led him away, Wheeler sighed in disbelief. “But I wore the juice,” he said.
Wheeler’s case is so famously absurd that it was later featured in an academic article, Unskilled and Unaware of It, by David Dunning and Justin Kruger. Their insight: People are often poor judges of their own competence. Worse still, we often get it exactly wrong. Incompetent people think they’re more competent than they actually are, while highly competent people tend to underestimate their skill.
While McArthur Wheeler is in a class by himself, Dunning and Kruger’s research carries an important message for the rest of us: Overconfidence can be a big problem, especially when it comes to the world of investments, where there’s as much noise as there is data and where there’s a strong temptation to predict what will happen next. After all, the hard part about financial planning isn’t the math, but rather the uncertainty.
What can you do to navigate this uncertainty? Here are three suggestions:
1. Stay the course. At its core, financial planning is simple: You have a set of financial goals, and you want to be sure you’re saving enough to reach those goals. But with the stock market’s regular ups and downs, it’s easy to get distracted.
In fact, there are people whose job it is to distract you. From TV to newspapers to social media, Wall Street “strategists” are all around us, dissecting and pontificating on the latest financial news. Last week, they were talking about interest rates. This week, they’re talking about China. Next week, they’ll be on to some new topic.
My advice: Tune them out. Remember that those strategists work for brokerage firms, and their goal is to get you to tinker with your portfolio, which generates trading commissions for them. Instead, you want to act like a racehorse wearing blinders. Focus straight ahead on your financial goals, and never let the sideshow of the week distract you from your plan.
2. Avoid big bets. In promoting index funds, the late Jack Bogle, founder of Vanguard Group, often talked about “the relentless rules of humble arithmetic.” Indexing worked, he said, because it kept costs low.
I completely agree with that. But that’s not the only reason indexing has produced better results than active management. Another advantage: Active managers can make risky, outsized bets in ways that index funds cannot. A case in point is former star fund manager Bill Miller, whose flagship fund once beat the S&P 500 for an astounding 15 years in a row.
During the 2008 financial crisis, however, Miller badly miscalculated. He thought people were overreacting and that the crisis would soon pass. This led him to double down on the stocks of AIG, Bear Stearns and other financial firms that lost nearly all their value. His fund was decimated and Miller was soon out of a job.
When you invest in a broadly diversified index fund, you avoid that risk. While you give up the opportunity to outperform the index, you are simultaneously buying yourself the peace of mind that you won’t dramatically underperform when a fund manager’s overconfidence gets the better of him or her.
3. Plan for a different tomorrow. As human beings, we have a limited ability to process data, and that biases the way we think about things. In particular, a phenomenon called recency bias leads us to place disproportionate weight on recent events and to discount events that happened longer ago. The result is that we generally assume things will continue tomorrow the way they’ve been going today and don’t consider the possibility of extreme change.
This is a problem because, of course, things do change—another reason it’s important to avoid overconfidence. In recent years, the stock market has delivered steady positive gains while interest rates, inflation and tax rates have all been near historic lows. While that’s all been very positive, it can and probably will change at some point. That’s why I always recommend considering, and planning for, a variety of scenarios other than the status quo. You can’t prepare for everything. But as you formulate your financial plan, it’s worth considering a tomorrow that looks a good bit different from today.
Adam M. Grossman’s previous articles include Beat the Street, After the Windfall and Out of Bounds. Adam is the founder of Mayport Wealth Management, a fixed-fee financial planning firm in Boston. He’s an advocate of evidence-based investing and is on a mission to lower the cost of investment advice for consumers. Follow Adam on Twitter @AdamMGrossman.