We’re Overconfident

WE TEND TO BE a self-confident lot, believing we’re above-average drivers, smarter than most and better looking. This isn’t necessarily a bad trait. Self-confident, optimistic individuals tend to be happier, more resilient and enjoy greater career success. But when our excessive confidence spills over into investing, it can hurt our portfolio’s performance.

As a group, investors will inevitably trail the market averages, once investment costs are figured in. Could you and I do better? In addition to our own investment costs, we face another hurdle: The markets are reasonably efficient, meaning they reflect all currently available information. Result: Stocks will tend to be fairly priced and finding bargains isn’t easy.

Yet, in our self-confidence, we believe we can succeed even as others fail. Experience ought to dent this self-confidence. But often, we’ll attribute our investment winners to our own skill, while ignoring our losers or blaming our mistakes on bad advice from others. Our self-confidence can be further bolstered as rising markets drive up our portfolio’s value, even if—in reality—we’re doing no better than most other investors.

On top of that, winning the investment game often appears deceptively easy. The market’s direction is always fiercely debated and yet, in retrospect, it can seem obvious that stocks were going to rise or fall. This hindsight bias can embolden us, giving us the courage to make big investment bets today. We see the market heading up or down and we convince ourselves we’ve spotted some major trend when, in truth, all we’re seeing are random price movements. We may also be afflicted by so-called availability bias: We hear plenty about stocks that soar and fund managers that beat the market—and far less about the losers—and this, too, can make the market seem easy to beat.

What’s the danger in all this? Our self-confidence has two potential downsides. First, in our self-confidence, we might make big investment bets—and those bets could go badly wrong. Second, the resulting activity can trigger hefty investment costs and big tax bills, and those will drag down our portfolio’s performance. A better bet: Give up the beat-the-market game and buy index funds instead. We discuss indexing in the chapter on investing.

Next: We Hate Losing

Previous: We Focus on Today

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