The dangers of overconfidence in investing
It is not uncommon to come across people who exhibit confidence in various domains, sometimes beyond their actual knowledge or expertise. In the world of investing, this tendency to assume expertise can result in significant financial losses. It is important to recognise that investment decisions should not be made based on assumptions or hearsay, but rather on sound financial knowledge and research.
But here’s the thing: we all have biases that affect our decisions, especially when it comes to money. There’s actually a whole branch of psychology that studies these biases and how they impact our perception of ourselves and our abilities.
One of the most interesting findings in this field is the Dunning-Kruger Effect. It’s a cognitive bias named after two US psychologists who found that people who are incompetent tend to think they’re better than average. They not only fail to recognise their own ineptitude, but they also wildly overestimate how well they perform in certain tasks.
In the study, the people who scored the worst in tests of grammar, humour, and logic were also the ones who thought they did great. As Dunning and Kruger wrote, “The same incompetence that leads them to make wrong choices also deprives them of the savvy necessary to recognise competence, be it their own or anyone else’s.”
On the other hand, those who are objectively recognised as experts tend to have a more realistic view of their abilities. They may even underestimate their knowledge relative to others. This is why the saying goes that becoming an expert isn’t just about acquiring knowledge, but also about recognising how much you don’t know.
In the financial markets, overconfidence can be dangerous, and humility can be beneficial. A 2006 paper by behavioural finance expert James Montier posed 17 questions to nearly 300 professional fund managers. The most common bias he found was over-optimism or the tendency to exaggerate their own abilities. This was particularly prevalent when the participants suffered from the illusion of control or thought they knew more than others.
For instance, 74% of the sample thought themselves above average at their jobs. But most of the remaining 26% thought they were average, with very few saying they were below average. This shows that even professional fund managers can delude themselves. And even those who did well in the test, tended to exaggerate their abilities and look for information that confirmed their views.
The truth is society rewards overconfidence. If our leaders told us the truth about uncertainty, we might not trust them as much as those who give the impression that they know what they’re doing. But when it comes to investing, it’s important to be wary of supposed experts who claim to know the future of the markets.
In the words of Warren Buffett, “Basically, any attempts to pick the times to buy or sell, I think, are a mistake for 99% of the population. To some extent, the smarter you try to be, the worse you do in your investments.”
In the end, it’s not about being the smartest person in the room, but about being humble and willing to learn from others. By recognising the dangers of overconfidence, investors can avoid making costly mistakes and build a more successful investment portfolio.