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Our Own Worst Investing Enemy

We've touched on how human behavior can lead to investment errors before, but I thought this was certainly worth sharing. My Buckingham Asset Management colleague Kevin Grogan has done some excellent research on behavioral finance, which can help in understanding the psychological factors that affect investment decision making. This week, we'll take a look at some of those factors.

In his 1998 paper "A Portrait of the Individual Investor," Werner De Bondt conducted fascinating research on individual investors by monitoring behavior of people in investment clubs. He recruited 45 investors (30 men, 15 women) from the National Association of Investment Clubs for his study. For 20 weeks, De Bondt tracked the group's forecasts for the future performance of the Dow Jones Industrial Average and of their own equity holdings. The study produced four key findings:

  • Investors were more optimistic about the future performance of their equity holdings than they were about the performance of the Dow. As a matter of fact, the predictions about the return of their holdings were three times that of the Dow.
  • They underestimated the volatility of their equity holdings.
  • Their forecast of their own portfolio was anchored on past performance.
  • They underestimated the degree to which their stocks moved with the overall market.
Their investing beliefs shed some light on their confidence in their own stock holdings. 89 percent of the investors agreed with the statement, "I would rather have in my stock portfolio just a few companies that I know well than many companies that I know little about." However, not a single person agreed with the statement, "Investing in stocks is like buying lottery tickets. Luck is everything and investment skill plays no meaningful role."

De Bondt's study showed that investors tend to be overconfident and tend to discount the benefits of diversification. This is a dangerous combination. Next, we'll learn how our behaviors can make us overconfident.

Follow the series: Our Own Worst Investing Enemy

  • Introduction
  • Why Overconfidence Is a Problem
  • Putting Our Investments in One Basket
  • How We Make Retirement More Difficult
  • Forecasting Should Be Left to the Astrologers