Financial Planning Blog

Although a healthy self-image and a bit of self-delusion are generally a good thing--and arguably necessary in starting a new business venture or while asking a cheerleader for a date--overdoing it isn't beneficial in investing. As Jason Zwieg observes in Your Money and Your Brain:

A pinch of confidence encourages you to take sensible risks and keeps you from storing all your money in the concrete bunker of cash. But if you think you're Warren Buffet or Peter Lynch, your inner con man is not telling little fibs; he's a big fat liar. You will never make the most of your investment potential if you think you have far more potential than you actually do. The only way to achieve everything you are capable of is to accept what you are not capable of.

Overconfidence in investing is a recipe for underperformance. Just like the 93% of us who believe we are above average drivers, many of us think we are more capable investors than we really are. Just as in Lake Wobegon, where "all the women are strong, all the men are good looking, and all the children are above average"--most of us seem to think we can beat the market.

When asked why people think they can beat the financial markets, Nobel Prize winner and behavioral economics pioneer Daniel Kahneman answers: "I do believe the answer in most cases is that people think they are better than anyone else--optimistic bias." This optimistic bias leads people to take risks they wouldn't take if they knew the real odds of success.

Kahneman often refers to "delusional optimism", where "people do things they have no business doing because they believe they will be successful." People are overconfident, often exaggerating our knowledge and over-estimating the amount of control we have over outcomes. We under-estimate what we don't know and downplay the role of chance. He explains, "We distinguish between games of skill and chance, but we see life as a game of skill. People tend to deny the role of chance: we see that in many studies of executives." This is why entrepreneurs believe they will succeed, even if they are aware of the enormous odds of failure--at least the odds of failure for all those other, less skillful entrepreneurs.

Overconfidence may well be a key driver in moving capitalism forward--or downward, as we have seen over the past few years. But for individual investors overconfidence can be a wealth destroyer, deceiving them in many ways. It often leads to taking on too much risk, because we over-estimate our odds of success. We may invest too much in that which we are most confident or familiar (e.g. company stock--think Enron). We may over-estimate our ability to evaluate a stock or other investment, and discount the abilities of the countless MBAs at Goldman Sachs and other Wall Street firms who are invariably on the other end of every trade we make.

One of the funny things about the stock market is that every time one man buys, another sells, and both think they are astute. --William Feather

However, as Terrance Odean points out in this article, the two biggest investing issues stemming from overconfidence are excessive trading and lack of diversification. Research by Odean and Brad Barber, appropriately titled "Trading is Hazardous to Your Wealth", showed how a large sample of active traders under-performed buy and hold investors by an incredible 6% per year. (More on Odean and Barber's research in Part 2.)

Diversification is a well understood tenet of wise investment. With an under-diversified portfolio, you are simply taking more risk than necessary for the expected return. Portfolio theory explains investors are compensated only for systematic risk, not the unsystematic risk that can be diversified away. Overconfident investors ignore this, or maybe have never have understood it, and hold too much of their pet investments. They believe they know more than "the market". Sure, they can strike it big, but they can also lose close to everything.

Diversification for investors, like celibacy for teenagers, is a concept both easy to understand and hard to practice. --James Gipson, former manager of the Clipper Fund

Of course, not everyone suffers from overconfidence or delusional optimism. I would argue that Kahneman (U.C. Berkeley, PhD-1961, and professor 1986-1993), Odean (UC Berkeley, BA-1990, MS--1992, PhD-1997, and Professor of Finance, 2001-present), and myself (UC Berkeley, MBA, 1981), have all been inoculated from the scourge of overconfidence by our association with the Golden Bears football team. This is a team whose only noteworthy achievement since going to the Rose Bowl in 1959 was THE PLAY. However, we likely suffer from a related bias--irrational optimism (not to be confused with irrational exuberance). We know that miracles have happened in the past, and just may happen again. Cal may play Boise State for the national championship, the U.S. may win the World Cup, and my old HP stock options may someday be above water.

See Part 2, Women are Rational, Men are Overconfident.