How Good do You Think You Are at Investing?

We all have a tendency to overestimate our abilities. A lot of the time, this is a good thing. Without any self-confidence, we would struggle to ever find a partner, apply for a job, or try a new hobby.

But there are also times when overconfidence has hazardous results – when we think we know things that we don’t actually know, or believe we know something others don’t.

Do you deliver better than average work at the office? Do you drive better than the average person on the road?

It is likely that you answered ‘yes’ to both of those questions.

There is a fair amount of research that finds that a majority of people will almost always rate themselves as ‘above average’ on these kinds of issues.

In 2018, a study found that 65% of Americans consider themselves of above average intelligence. A survey of 1 million high school students in 2005 reported that 70% of them believed that they were above average leaders. And a famous paper published all the way back in 1981 discovered that 88% of a sample of American graduate students and 77% of Swedish graduate students rated themselves as better-than-average drivers.

Our positive illusions

Statistically speaking, it is obvious that these responses can’t be accurate. By definition, a significant majority of any sample can’t be above average.

Humans, however, have a natural tendency to believe that they are better than they are. And, for the most part, this is not unhealthy. In a 2011 paper, researchers from the University of Amsterdam wrote:

“Mentally healthy people blissfully suffer from what are called positive illusions: they overestimate their abilities, as well as their control over events, and they underestimate their vulnerability to risk.”

However, this does come with its drawbacks. For example, surveys have found that as many as 88% of people use their mobile phones while they are driving, even though the risk is well known. One can assume that people do so anyway because they have a belief in their own superior driving abilities.

The money problem

Unfortunately, many people also overestimate how much they know about investing and finance. They think that they can make better decisions than the average person, and that they can beat the market.

This is not just among everyday investors. Professional fund managers have the same bias, even though they are also unlikely to be right.

Research over many decades has shown that most active managers don’t beat the market. The most recent S&P Indices vs Active (SPIVA) scorecard in the US shows that a little over 15% of US large-cap fund managers beat the S&P 500 over the past five years. Over 10 years, less than 10% managed to outperform.

However, a study in 2006 found that 74% of fund managers consider themselves above average.

Underestimating risk

For individual investors, however, the risks can be really meaningful. As a new paper about financial literacy in Saudi Arabia points out:

“Overconfidence in financial knowledge results in poor financial choices and ultimately leads to financial losses for individuals.”

The reality is that being too confident about our investment ability means that we underestimate the risks we might be taking. When we are sure that we are right, we don’t think enough about what might happen if we are wrong.

A clear recent example has been the crypto world, where a number of cryptocurrencies have imploded. Many people have lost a lot of money because the ‘investments’ they made into these tokens have turned out to be worthless.

Right place, right time

Unfortunately, overconfidence is highly prevalent in crypto. That is because it is so difficult to understand cryptocurrencies, what they do, and therefore why their prices go up or down.

The chances are that people who were just lucky to be in the right place at the time when everything was going up let themselves believe that they had been smart to invest. So, they took on more and more risk.

Unfortunately, getting caught up in the hype has now left many of them with huge losses. Since they were too confident in what they thought they knew, they underestimated the risks.

And what happened next is a good lesson for every investor to learn.

To discuss your long-term investment strategy, speak to a professional.

Disclaimer – *The information provided herein should not be used or relied on as professional advice. No liability can be accepted for any errors or omissions nor for any loss or damage arising from reliance upon any information herein. Always contact your professional adviser for specific and detailed advice.
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