Why Overconfidence Can Be Bad for You

Last Updated Apr 19, 2010 9:44 AM EDT

Previously, we discussed the issue of investor overconfidence. As Gary Belsky and Thomas Gilovich point out in their excellent book Why Smart People Make Big Money Mistakes, one reason people stay overconfident is because they conveniently remember their successes but repress their failures. Unfortunately, being overconfident about your investment skills can lead to all kinds of mistakes. For example:
  • You could avoid diversifying your portfolio because you're confident that your investments are safe.
  • You might own lots of your employer's stock, because you're confident about its prospects.
  • Your equity allocation might exceed your ability, willingness or need to take risk because you're confident in your forecast for the equity markets.
  • You might trade frequently, confident in your market-timing skills.
As Belsky and Gilovich point out, being overconfident can also lead you to think you're in better financial shape than you really are. They provided some evidence from a study by the International Association of Financial Planning. 83 percent of respondents with children under the age of 18 said they had a financial plan, and 75 percent expressed confidence in their long-term financial health. However, less than half said they were saving for their children's education, and less than 10 percent described their financial plan as addressing basic issues such as investments, insurance and savings. Being overconfident can lead to being unprepared.

Belsky and Gilovich offered this advice: "Any individual who is not professionally occupied in the financial services industry (and even most who are) and who in any way tries to actively manage an investment portfolio is probably suffering from overconfidence. That is, anyone who has confidence enough in his or her abilities and knowledge to invest in a particular stock or bond (or actively managed mutual fund or real estate investment trust or limited partnership) is most likely fooling himself. In fact, most such people (probably you) have no business at all trying to pick investments, except perhaps as sport. Such people (again, probably you) should simply divide their money among several index mutual funds then turn off CNBC and block most financial Web sites." That advice alone is worth the price of the book.

It's said about attorneys that only a fool has himself as a client. The same thing could be said about investment advisors. Most advisors I know are willing to admit that they're better advisors than investors. The reason is that while they're able to provide rational, unemotional advice on your financial situation, they're subject to the same type of behavioral mistakes we all are when it when it comes to their own situations, simply because they're human.

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    Larry Swedroe is director of research for The BAM Alliance. He has authored or co-authored 13 books, including his most recent, Think, Act, and Invest Like Warren Buffett. His opinions and comments expressed on this site are his own and may not accurately reflect those of the firm.