Our society places a high value on confidence and most people identify it as a key element for success in life. But does it necessarily hold true for successful investing?
In daily life when we talk about confidence we are referring to the degree of certainty that we hold in the validity of our knowledge, predictions about the future, or decisions. In other words, self-confidence reflects our opinion about our own abilities. However, not everyone is realistic about their limitations and their abilities.
People that lack confidence are at one end of the spectrum. They underestimate their understanding of the facts and their ability to make sound decisions. This often leads to over-analyzing situations and inertia or even paralysis in making decisions.
Overconfident people on the other hand overestimate their predictive and problem solving abilities. Experts have long known that people in general, and men; in particular, tend to overestimate their abilities in a wide variety of areas from driving a car, solving problems and investing their money. When they decide on a course of action, it is done with a high degree of certainty that it is the right one. In reality however they may have failed to seek clarification and expert counsel, consider all the available facts, and identify the potential consequences of their decisions. These oversights often result in poor choices that can come at a heavy price. Overconfidence and its ramifications has been an important area of study for behavioral economists, especially in the area of investing. This tendency to overstate what they know about a particular investment, the financial markets or the overall economy can wreak havoc on their finances in several ways:
1. Taking on unnecessary and excessive risk by concentrating their investments in a few industries or companies that they expect will outperform. By definition, concentrated portfolios are less diversified and expose investors to greater risk of loss.
2. Excessive trading in an effort to time the financial markets. This has proven to be a strategy for failure even when executed by the most sophisticated investors in the world. The research in this area is broad, deep, and clear. Market timing results in investors earning only half of what they otherwise could have earned by simply sticking with a well constructed long-term portfolio. When the effects of trading costs and taxes are introduced the results are even more disappointing.
3. Reliance on intuition or “gut-feelings”. There is no substitute for facts, logic, and common sense when it comes to successful investing. It requires a commitment of time and effort and the application of sound investing principles.
4. Not adequately preparing for the future. Believing they have a sound plan to reach their financial goals and actually having one are two different things. While most Americans list a comfortable retirement as their highest priority and largest liability, fewer than half have a plan in place to reach that goal.
There is no question that confidence is an admirable quality and the basic foundation for optimism, motivation, and success. It is overconfidence, which is the belief that we know more than we actually do and acting on that belief that can undermine our financial future.