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Our Own Worst Investing Enemy: Why Overconfidence Is a Problem

Yesterday we learned that investors tend to be more optimistic about their own equity holdings than they are about the overall market. Today, we'll look at the effect of investor overconfidence on portfolio performance.

We've explored overconfidence before, noting that it can cause you to believe your stock picks will outperform the market or believe you're in better shape financially than you actually are. Still, it continues to be an important consideration, especially since it can lead to lower returns.

For example, many investors earn lower returns outside their 401(k) plans than inside, likely because they trade too much outside the plan. Overconfidence in your abilities to beat the market is what causes investors to trade too much.

A series of studies by Brad Barber and Terrance Odean looked at the performance of thousands of investors over various six-year periods. They found that the more investors traded, the worse the results. The only people who made money from frequent trading are the brokers.

It should be noted that men and women aren't created equal when it comes to overconfidence. Barber and Odean found that the stocks picked by men and women performed about the same. However, men traded 45 percent more than women. Trading reduced men's net returns by 2.65 percent per year, compared with a 1.72 percent reduction for women.

Tomorrow, we'll look at how our behaviors can cause us to put all our eggs in one basket.

Follow the series: Our Own Worst Investing Enemy