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Are You Overconfident of Your Skills?

I have two quick questions for you:

  • Are you better than average in getting along with people?
  • Are you a better-than-average driver?
About 90 percent of respondents answer positively to those types of questions. Obviously, 90 percent can't be above average -- we don't live in Lake Wobegon. While overconfidence can be a healthy attribute -- such as when it helps create a positive framework to get through life's experiences -- overconfidence in our investment skills can lead to investment mistakes.

The following illustrates the "Lake Wobegon effect." A survey of investors published in the Journal of Wealth Management found that investors persistently forecasted that their portfolios would outperform the market.

Market Portfolio
June 1998

13.4%

15.2%

February 2000

15.2%

16.7%

September 2001

6.3%

7.9%

Professors Richard Thaler and Robert Shiller note: "Individual investors and money managers persist in their belief that they are endowed with more and better information than others, and that they can profit by picking stocks. While sobering experiences sometimes help those who delude themselves, the tendency to overconfidence is apparently just one of the limitations of the human mind."

One of the ways overconfidence can hurt you is by causing you to believe you can somehow identify which active managers will be among the few that will deliver future outperformance. You may very well pick correctly, but you should consider the failure of institutional investors, with far more resources than individuals, to succeed in that effort. Picking correctly is typically due to luck more than skill.

Overconfidence also leads to excessive risk taking, including the failure to diversify. You may end up seeing other people's decisions as the result of mood, feelings, intuition and emotion, while seeing your own resulting from objective and rational thought. You may also end up seeking only evidence confirming your own view and ignoring contradicting evidence.

Professor Meir Statman advises that you can avoid the mistake of overconfidence by keeping a diary. "Write down every time you are convinced that the market is going to go up or down. After a few years, you will realize that your insights are worth nothing."

On Wednesday, we'll look at an example of how overconfidence can hurt your portfolio.

Further reading: My MoneyWatch colleague Allan Roth explored this topic in great detail in his article, "Investing Reality Check: Why You Think You're Above Average."

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