How’s your (Over)confidence? (1)
By Chris Castles
So tell me, how would you rate yourself as a driver – below average, average or above average? If you’re like most of us you probably answered ‘above average’.
In 1965 Caroline Preston and Stanley Harris, two psychologists at the University of Washington, asked 50 drivers to rate their own ‘skill, ability and alertness’ the last time they were at the wheel. Almost two thirds said they were at least as competent as usual. What’s so strange about that you might say? Well, all of the people interviewed were in hospital. They’d started the trip in their own car and ended up in hospital. According to the police department 68% of these drivers were responsible for their own accident, 56% totalled their vehicles, and 44% would face criminal charges. Only 10% admitted that they were partially responsible for their accident. Were these people crazy? As it turns out – No. A later survey of drivers found that 93% believed themselves to be above average drivers. So if you answered above average to my first question, congratulations, you’re in the majority!
So what’s that got to do with investing? Well that’s a behavioural phenomenon called overconfidence. While positive thinking can be useful, extreme optimism is dangerous for your wealth. Consider these fatal flaws.
– We can generally make a level headed estimate of a person’s chance of success, but when we come to ourselves we generally get it wrong. That leads us to taking risks we regret down the road.
– We trust the ‘familiar’ and so we tend to overinvest in things, areas, industries, countries that are familiar to us.
– We overestimate the control that we have over our own circumstances and so we don’t plan ahead properly and we’re surprised when our investments don’t work out.
– How many times have you said that you ‘knew that would happen’. We tell ourselves we knew even if we had no idea what the future would hold. By thinking we knew what was going to happen we develop what’s called ‘hindsight bias’. It makes us believe we can see what’s coming and stops us learning from our mistakes.
– We don’t like using the words ‘I don’t know’. The more we know, the more we think we know more than we actually know. That’s overconfidence.
So the next time you think you know ask yourself these questions:
– Am I really above average? Why?
– Do my decisions really shape my investment returns? How?
– Do I know as much as I think I do? Why?
– Is this a great investment? Write down why you’re buying it, and what the trigger is to sell it.
These aren’t foolproof but they’ll go a long way to helping keep your (over)confidence in check.
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(1) – Adapted from ‘Your Money and Your Brain’ by Jason Zweig