Are You Delusional About Your Investments?

On Wednesday, we saw that many investors have a hard time accepting "average" returns of the market. Today, we'll see that one possible cause is because they don't know how their past strategies have actually performed.

The study "Positive Illusions and Forecasting Errors in Mutual Fund Investment Decisions," sought the answer to the question, "Why do investors spend so much time and money on actively managed mutual funds despite the fact the vast majority of these funds are outperformed by passively managed index funds?" The authors found that investors delude themselves.

They found most participants had consistently overestimated both the future performance and past performance of their investments. In fact, more than a third who believed they had beaten the market had actually underperformed by at least 5 percent, and at least a fourth lagged by at least 15 percent. This finding echoes others who have found that investors often overestimate their returns. Biases such as this contribute to suboptimal investment decisions.

Psychologists have also found that investors who have the "I'm in charge" feeling have an even greater ability to delude themselves. A study of U.S. retirement plan investors who could either choose their own mutual funds or permit someone else to decide for them found that both groups deluded themselves about their performance. The investors who allowed others to make the selections on their behalf only overstated their returns by more than 2 percent. The group that was "in charge" overstated returns by almost 9 percent.

You certainly have the right to try to beat the market. However, the evidence suggests it's a mug's game. At the very least, you should know the odds of success. Unfortunately, it seems many delude themselves about those odds because they don't know their own track records. This type of self-delusion helps to explain why investors exhibit that common human trait of overconfidence. Most people want to believe they are above average. And so the disconnect investors have between reality and illusion persists.

It's important both to measure your investment returns and to also compare them to appropriate benchmarks. Doing so will force you to confront reality rather than allow an illusion to undermine your ability to achieve your financial objectives.