Financial Planning Blog

Although you may be extremely confident that you don't suffer from the financially destructive behavioral bias of overconfidence, you may have a friend who could benefit from a little advice on dealing with this tendency. Here are a few suggestions to consider.

• Recognize the danger. Acknowledge that overconfidence can be hazardous to your financial well-being and that you too can be susceptible to its effects. Obviously, we need enough confidence to move forward and make decisions in our financial life. However, just like a lot of things in life (e.g. food, alcohol, reading financial blogs), moderation is key. Recognize your limitations, and don't overestimate your skills, knowledge, and predictive capabilities. A little humility is not only an attractive quality in a person--it is a necessary condition for successful financial planning.

It's not what a man don't know that makes him a fool, but what he does know that ain't so.--Josh Billings, nineteenth century American humorist

• Men, listen to your wives. If behavioral researchers are correct, your wife is less likely to be an overconfident investor than you are. And, it is a safe bet that she is not as confident in your investing ability as you are. Use this to your advantage and consult your spouse on investment strategy and decisions. (This goes both ways, obviously. Women, consult your husbands.) It could just be that two heads are better than one, and two ways of looking at things may result in more wisdom and understanding. Sure this takes longer, but the joint decision-making and buy-in is a positive thing. Besides, taking longer isn't necessarily a bad thing. My guess is that the bad, impulsive decisions you avoid will more than offset the few time-sensitive opportunities you miss.

An excellent wife, who can find? For her worth is far above jewels. The heart of her husband trusts in her, and he will have no lack of gain. --Proverbs 31: 10-11

• Benchmark, document and review. Check your investment performance against relevant benchmarks and determine if you are really as capable as you think. Also, write down your reasoning for buying or selling a particular investment, and check it later. (Do this right away, since your recollection of your reasoning will be tainted by the passage of time.) Or, if you dare, write down your predictions for the economy and the financial markets. Were you right about that company's prospects, that interest rates were set to rise, or that the market was set for a correction? How good did you do--not just your investments, but your reasoning? We all tend to have some "hindsight bias", so this documentation helps us to see if our investment performance was really that good, or if our predictive abilities were as acute as we remember. You may outperform the benchmarks sometimes, and your predictions and reasoning may have been right on target. However, you will undoubtedly underperform for periods, and your forecasts may be laughable at times. This documentation will encourage a bit of humility, and serve as a sobering reminder of how difficult it is to be consistently right.

Prediction is very difficult, especially if it's about the future. --Nils Bohr, Nobel laureate in Physics

• Keep track of your mistakes. In Your Money and Your Brain, Jason Zweig recounts how Christopher Davis of Davis Funds has the "mistake wall" outside his office. This is where his company's worst investments are memorialized. For Davis, mistakes are bad decisions that could have been prevented with better information or better analysis. The key thing here is the practice of recognizing, remembering and learning from your mistakes, rather than suppressing and denying them. Your own personal mistake wall or folder will not only remind you of your limitations, but of those lessons you have learned and paid for.

All men make mistakes, but only wise men learn from their mistakes.--Winston Churchill

Experience is that marvelous thing that enables you to recognize a mistake when you make it again.--Franklin P. Jones

Michael Pompian in Behavioral Finance and Wealth Management points out that an important implication of overconfidence is that it may leave many investors ill prepared to meet their future objectives, whether it is funding college for their children or replacing their income in retirement. He claims:

...most parents of children who are high school aged or younger claim to adhere to some kind of long-term financial plan and thereby express confidence regarding their long-term financial well-being. However, a vast majority of households do not actually save adequately for educational expenses, and an even smaller percentage actually possess any "real" financial plan that addresses such basics as investments, budgeting, insurance, savings, and wills. This is an ominous sign, and these families are likely to feel unhappy and discouraged when they do not meet their financial goals.

Don't let overconfidence contribute to you being financially unprepared for your future and the disappointment it will bring. Invest the time and effort in creating a realistic financial plan that will give you a good shot at meeting your objectives. Contact Table Rock Financial Planning, or another hourly, fee-only advisor from the Garrett Planning Network to assist you in this effort.