Overconfidence leads investors to believe they can make buying and selling decisions that would result in their performance beating the indexes. Most professional fund managers don’t beat the indexes on a consistent basis, so there is little reason to believe that amateur stock-pickers will be able to succeed where professionals have failed.
Are you overconfident? Kiplinger offers a questionnaire to help you determine whether you are more sure of your thoughts than perhaps you should be. Take the quiz here. The questions are not all related to finances, but are designed to measure your level of confidence overall. If you’re like me, the ranges you selected for the answers you didn’t know where too shallow.
Once you’ve had a chance to evaluate your results, take this second quiz and see if you can change your score.
Although overconfidence helps you accomplish your goals in life, it can damage your finances by leading to believe you’re a savvier investor than you are. So here are four ways to settle down and accept reality.
1. Invest mostly in index funds. Professionals can’t beat the indexes consistently, so it’s unlikely you will be able to either. Investing in index funds does not guarantee “average” returns, it will result in your investments performing better than actively-managed funds.
2. Invest regularly in equal amounts. You can’t time the market. I tried this recently, buying shares in Toyota Motors after one announcement of additional recalls. My belief is that Toyota will eventually recover, so I’ll hold on to this for some time. But if my goal were to make money quickly, I would have failed. More bad news propelled the stock price lower.
Dollar-cost averaging into the stock market, purchasing the same amount of an index fund at regular intervals, takes the human tendency to fail at decision making out of the process.
3. Don’t invest in the company you work for. It’s hard to have an objective opinion about your employer. Your too close to the situation. Also, executives will often say what is necessary to boost the confidence of their employees while not addressing potential problems. You are already invested in your company due to the salary and benefits you receive.
You may be required to invest in your company’s stock through a retirement plan, but you should sell these investments and buy index funds as soon as possible. My actions should serve as an example of what not to do. I invest 10% of my salary in company stock at a 15% discount through my company’s stock purchase plan, but I’ve been reluctant to sell while the stock has declined.
4. Eliminate or reduce emotions when making financial decisions. Emotions can’t simply be turned off. They’re essential for our brains to function. Nevertheless, separating emotions from money as much as possible will offer better financial results than reacting to your emotions.
A study in 1986 (McCormick, Walkey and Green) revealed that 80% of the survey respondents consider themselves better drivers than average, so it is not surprising we overestimate our financial abilities as well. No one wants to hear they’re not better than average, however. This overconfidence allows us to break out of our comfort zone but can be damaging to finance if allowed to rule decisions with money.
Published or updated February 16, 2010. If you enjoyed this article, subscribe to the RSS feed or receive daily emails. Follow @ConsumerismComm on Twitter and visit our Facebook page for more updates.