Justifiable confidence in our own abilities helps us deal with many things in life – including some of the inevitable setbacks. It can be our friend.
However, over-confidence is a common behavioural trait that can rapidly transform into one of an investor’s worst enemies.
In a recent article in The New York Times, investment author and commentator Gary Belsky looked at the negative impact of investor over-confidence. (Belsky is the author of the personal financial book Why Smart People make big money mistakes and how to correct them.)
There are a range of books with similar titles such as Why smart people do dumb things with their money. You quickly get the message: Investor behaviour really matters.
Belsky writes that "despite the spectacular growth" of index-tracking managed funds, "millions of amateur investors continue to actively buy and sell securities regularly".
And he rhetorically asks: "… why do amateurs believe they can outperform the professionals – or even identify those pros who will outperform?"
Belsky believes the answer to his own question lies with the "biases and cognitive errors" of investors including an overinflated view of their abilities. And he places over-confidence and over-optimism high on his list.
One way that many investors keep their "biases and cognitive errors" at bay is to hold the core of their appropriately-diversified portfolios in low-cost conventional index funds and/or Exchanged Traded Funds (ETFs), tracking broad market indices. With this approach, any active side of their portfolios – meaning direct shares and actively-managed funds – form smaller satellites.
Particularly in this low-interest and volatile investment environment, it is critical to have realistic, not overly optimistic expectations for returns. Realistic investors who are not over-confident would be less tempted to take excessive risks in the pursuit of returns.
Renown behavioural economist Dr Richard Thaler discussed the destructiveness of investor over-confidence in his latest book, Misbehaving, published by Penguin. (See The right nudge for human investors, Smart Investing, February 16.)
"People become overconfident because they never bother to document their past record of wrong predictions, and then they make things worse by falling victim to the dreaded confirmation bias – they only look for evidence that confirms their preconceived hypotheses," Thaler writes.
He believes investor over-confidence is a "highly plausible" explanation for heavy trading volumes on security markets.
A Vanguard research paper, Required or desired returns? That is the question, makes the point that an investor’s personal past experiences can influence expectations for investment returns – and whether those expectations are realistic.
For instance, a past setback may make an investor excessively risk-averse. And a past investment success may have the opposite influence – on their expectations for returns and on their level of confidence.
An understanding of how our behavioural traits can play tricks on us as investors really reinforces why the principles of sound investment practice really matter, as often discussed by Smart Investing.
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Robin Bowerman is Head of Market Strategy and Communication, Vanguard Australia. As a renowned market commentator and editor Robin has spent more than two decades writing about all things investment. |
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