Overconfidence can hurt the return on your investment. how to fix it

  Overconfidence can hurt the return on your investment.  how to fix it

Trevor Williams | Digital vision | Getty Images

If you’re like most people, you probably assume that you know a lot more than you realize, even if you don’t.

This false sense of security allows us to be decisive in the face of great uncertainties.

But when it comes to investing, it can backfire, according to Phil Fernbach, professor of marketing at the University of Colorado and director of the Center for Research on Consumer Financial Decision Making.

Fernbach, a new academic article co-authored with Daniel Walters, professor of marketing and director of the Marketing Insights Lab at INSEAD, sets out to find out.

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Their conclusion: the combination of biased memories and perceptions of overconfidence can erode the performance of individual investors.

“Overconfidence as an investor or trader is really dangerous because you can get yourself into a lot of trouble,” Farnbach said.

Why your memories are likely to be distorted

When it comes to your past investing performance, your memory can lead you astray.

“If I ask you, ‘How well have your past investments worked? “You will remember because it was better than it actually was,” Farnbach said.

This supports the belief that you are good at investing or trading despite evidence to the contrary, he said.

Usually people remember the good times and forget the bad times. It contributes to a positive self-image.

This too rosy view of the past contributes to overconfidence.

Overconfidence and investment decisions

When it comes to investing, in particular, a lot of confidence isn’t necessarily a good thing.

“If you don’t have an accurate view of the data, you’ll have an exaggerated idea of ​​your capabilities,” Fernbach said.

Overconfidence contributes to a high frequency of transactions. Yet previous research has shown that the more trades an investor has, the less likely they are to be successful with a buy and hold strategy.

At some point the bull market ends and many of these swing traders day traders find it not that easy to beat the market.

Phil fernbach

Director of the Center for Research in Consumer Financial Decision Making at the University of Colorado

Certainly, investing requires a number of transactions, Fernbach said. For example, it makes sense to manage risk by rebalancing periodically. Investors may want to update their portfolios by adding new names and partnering with older ones who no longer have good prospects.

But people get in trouble when there is too much fuss over their wallets, he said.

If the stocks go up, they want to buy. Conversely, if all goes wrong, they want to sell.

“This type of reactive trading is really bad because it leads to a lot of selling at the bottom and buying at the top,” Farnbach said.

The buy and hold approach tends to outperform over time for passive investments such as index funds. But in a bull market, when people can trade entry and exit strategies while making a profit, the performance gap may not be that large.

“At some point the bull market ends and a lot of these swing traders, day traders find it not that easy to beat the market,” Farnbach said.

What to do before investing?

If you are like many investors, you probably don’t know how a false sense of security can lead you astray.

According to Fernbach, there is a way to combat this.

Before taking any action, review your past performance. Based on research, it helps people check their actual performance with reality.

“They remember the winners because they were better than them,” Fernbach said. “They remember the losers weren’t as bad as them.

“All of these things can be summed up by just looking at the data, your actual past performance,” he said.

The research is based on multiple studies of people who were actively investing from 2018 to 2020, typically those with at least $ 1,000 in the market and at least two individual stocks.

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