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Studies have found that the majority of people believe that they are above-average -- whether they’re rating their investing ability or their driving skills --even though by definition only 50% of any group will truly be above average. In one well-known study, 74% of 300 fund managers believed they were above average. And the remaining 26% of the managers thought they were average. Very few believed they were below average, even though statistically, many of these managers had to be below average.
Our tendency to believe we’re more skilled than we actually are is called overconfidence. It’s a common behavioral bias and, if left unchecked, it can have a profound effect on our investments.
Too Much Confidence Can be Hazardous to Your Financial Health
Overconfidence can lead us to misconstrue decisions based on intuition or emotion as being based on objective information and rational thinking. Perhaps you sold out of stocks early in 2008 and ended up avoiding the worst of the 2008 bear market. In hindsight, you may feel like you somehow “knew” the market was going to experience a historic decline, and that could lead you to believe that you’ll always be able to avoid down markets.
“Because we’re human, we’re really good at taking a prior success and projecting it into the future,” financial writer Carl Richards wrote. “The end result is an unwarranted, and unhealthy, belief that somehow we’ll come out on top again. We usually fail to take into account all the things that led to our last success.”
Too Much Confidence, Too Much Risk
Overconfidence can lead you to take on more risk than is appropriate. If you believe you are adept at sidestepping market downturns, you might invest in more concentrated funds like sector funds because you believe you’ll be able to avoid the risk of these funds. And you may not recognize the value of owning bonds, which are often used in an attempt to buffer stock market declines.
No one is immune to overconfidence. It affects both individual investors and professional investors alike. A 2010 article in the New York Times looked at the overconfidence of Long Term Capital Management, “a hedge fund run by extremely smart people (Nobel Prize winners in fact)”. Long Term Capital Management was very confident that it could avoid substantial losses, but the firm “ended up losing $3 billion in 1998 and was bailed out by a group led by the New York Fed. The geniuses at Long Term were positive that the most they could ever lose in a single day was $35 million, and then on Aug. 21 they lost $553 million.”
Overconfidence can be hard to recognize because it stems from our inability to see ourselves and our skills objectively. But there are simple and effective ways to minimize the impact overconfidence can have on our portfolios.
1. Set realistic expectations
We need to have realistic expectations of our investments and ourselves. No investment always outperforms. Even the funds and advisors with the very best long-term performance have periods when they underperform. And no one can reliably time the market, either.
A better option is to find a portfolio that allows you to ride through the markets ups and downs. For many investors, that means holding a balanced portfolio that includes both stocks for potential growth and bonds to attempt to buffer the volatility of stocks.
2. Revisit your investment decisions over time
One simple way to counter overconfidence is to revisit your investment decisions on a regular basis. Set a schedule, if necessary, that prompts you to consider your overall allocation every quarter or every year. The Upgrading strategy we use to manage the Upgrader Funds leads us to reassess our positions every month.
3. Mitigate risk
Since overconfidence can lead you to take on more risk, you should have a process in place that helps you mitigate risk. We suggest limiting how much of your portfolio you’ll devote to funds that invest in a single sector – and then stick to this limit even if you “have a feeling” that a certain sector is about to take off.
We do this in the Upgrader Funds. The Upgrader Fund (FUNDX) has limited exposure to more aggressive stock funds, like sector and single-country funds, and the Flexible Income Fund (INCMX) has limited exposure to more aggressive bond funds, like lower-quality bonds.
4. Rely on a disciplined strategy
Perhaps the best way to counter overconfidence is to follow a disciplined investment strategy. Your strategy should help you make investment decisions based on numbers, not your intuition about a certain area of the market or your guesses about where the market’s headed.
The Upgrading strategy we use to manage the Upgrader Funds is quantitative: we’re led to make decisions based on how a fund is performing compared to other funds with similar risk. We don’t make investment decisions based on our opinion of a given fund or a certain industry, and we don’t invest based on market predictions. Our buy and sell signals are based on extensive research and have a long history of actual investment performance.