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You’re Not That Great: 4 Ways to Combat Overconfidence

This article was written by in Investing, People. 7 comments.

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.

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About the author

Luke Landes is the founder of Consumerism Commentary. He has been blogging and writing for the internet since 1995 and has been building online communities since 1991. Find out more about Luke Landes and follow him on Twitter. View all articles by .

{ 7 comments… read them below or add one }

avatar 1 Anonymous

I am not impressed with those quizes.

They ask random questions about things the person answering may have no idea at all and then tell them to try to be 90% sure but to not use too broad of a range. That encourages you to try to pick a smaller range which you have no way of knowing the answer for.

For example, bricks in the great pyramid. How big is the base? I have no idea, I will have to guess. Howe big are the bricks used, I have no idea, I will have to guess. Are the bricks all the same size, I have no idea, I will have to guess. Is the pyramid mostly hollow inside or mostly solid bricks, I have no idea, I will have to guess. But you are instructed to try not to have too narrow a range. The only reasonable answer is somewhere between 100 and 100 billion, but that is clearly not an answer that tells anything so you try to pick something like 20,000 to 100,000 and then you are way off. Which also tells nothing because you know zero about the makeup of the pyramid. The problem is the instructions lead you to believe that answering 100 to 100 billion is a cop out but its the only valid answer for someone uninformed on the makeup of the pyramid. I don’t see how this quiz measures anything.

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avatar 2 Anonymous

I don’t know about keeping emotions out of it. I know you are talking solely about financial returns but for a lot of us, there’s more to it than that. A good many people have a difficult time getting started in the stock market. It’s a confusing place. Investing in a company you love, be it a clothing store you can’t live without or a company whose values mirror your own, is a good way to get your feet wet. As with any investment, you certainly don’t want to invest money you can’t afford to lose, but investing in a company or business you love makes you feel good and is a good way to get started.

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avatar 3 Anonymous

It is sensible that on the second quiz, I double the size of the range and get more than twice of better result. Too bad they don’t stipulate the size of the range allowed; or is that the whole point of this exercise? Of course you will have better chance to be correct when you broaden the range.

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avatar 4 Luke Landes

That’s exactly the point. We’re free to make the range as large as we like. The fact that people generally start with a small range on the first quiz (whether the right answer falls within that range or not) speaks to the level of confidence. After receiving feedback, you take the second quiz, broaden your ranges, and improve your score.

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avatar 5 Anonymous

Hey Flexo

With regards to your third point, I don’t think I quite agree. I think the decision to hold onto, buy or even sell a company’s equity is dependent on the company. I know several people who’ve dollar cost averaged their way, via regular employee share purchase plans to eventually become millionaires several times over, due to dividends and share price appreciation. Would you have the same opinion, if you were working at Goldman Sachs?

In addition, simply selling shares in a company because the price is going down runs contrary to your point about investing regularly in equal amounts, don’t you think?

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avatar 6 Anonymous

@Arjun, I respectfully disagree. Almost nobody should be holding a large percentage of their equity in just one company. Even those few serious investors who go for super concentrated portfolios would look to hold at least 3-5 stocks, as far as I’ve seen.

In contrast, anecdotally at least, many people with employee share plans are very overweight in the shares of their employer. I’ve met several people of the years who hold no other equities at all outside of funds in tax exempt plans for retirement etc.

If you’re going to be so dangerously concentrated, doing so in the same company that employs you (and who possibly is on the line for paying your pension or other benefits, too) is the height of folly.

I’d rather hold all the shares of the best competitor if I was forced to choose one or the other!

As Flexo says, sell as soon as you can once any beneficial holding period has passed and diversify, IMHO.

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avatar 7 Anonymous

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