The Overconfidence Gap
Over the years, the many people I’ve worked with have had both good and bad traits. No doubt they’d think similar things about me. The one trait that I find most tiring is a high overconfidence gap, which I define as the difference between how good you think you are and your actual abilities. Confidence is a useful thing in many contexts, but it can be deadly for your finances.
As a baseball coach, I routinely talk up players’ confidence before sending them to bat. Believing you can hit the ball improves how hard you try and leads to better outcomes. Confidence also leads to more improvement over time. Too much confidence can cause problems, but for the most part confidence is useful in baseball.
I’ve watched the cycle many times. A batter goes to the plate with confidence and either gets a hit or doesn’t. Failing causes a short-term blow to the ego that fades before the next at bat. Confidence helps. Even overconfidence helps within limits.
When it comes to investing, a large overconfidence gap can be very dangerous. You need some confidence to be able to take your money out of a savings account, but too much confidence leads investors to take wild chances on their hunches. I’ve done it myself piling most of my net worth into one stock. But I don’t do this anymore.
The cycle I observe among some high-tech workers is they are very confident in their assessment of some stock. They buy, the stock tanks, and they protect their egos with some explanation of why the bad investment wasn’t their fault. Then they do the same thing over again time after time.
It can be very hard to examine a stock, form a strong opinion, and admit to yourself “it’s just a coin flip whether I’m right or wrong.” It’s staggering that we often think we can do a little work on the side and beat full-time investment professionals at their game.
Even more baffling are the stock-pickers who don’t even read company financial statements. It’s impossible to pick stocks well without examining financial statements and comparing their meaning to the stock’s current price. A quick test I have for those touting a stock is to see if they can quote any of the company’s major financial figures from memory.
Confidence is important in many areas of our lives, but overconfidence can hurt you financially. Mind the overconfidence gap.
As a baseball coach, I routinely talk up players’ confidence before sending them to bat. Believing you can hit the ball improves how hard you try and leads to better outcomes. Confidence also leads to more improvement over time. Too much confidence can cause problems, but for the most part confidence is useful in baseball.
I’ve watched the cycle many times. A batter goes to the plate with confidence and either gets a hit or doesn’t. Failing causes a short-term blow to the ego that fades before the next at bat. Confidence helps. Even overconfidence helps within limits.
When it comes to investing, a large overconfidence gap can be very dangerous. You need some confidence to be able to take your money out of a savings account, but too much confidence leads investors to take wild chances on their hunches. I’ve done it myself piling most of my net worth into one stock. But I don’t do this anymore.
The cycle I observe among some high-tech workers is they are very confident in their assessment of some stock. They buy, the stock tanks, and they protect their egos with some explanation of why the bad investment wasn’t their fault. Then they do the same thing over again time after time.
It can be very hard to examine a stock, form a strong opinion, and admit to yourself “it’s just a coin flip whether I’m right or wrong.” It’s staggering that we often think we can do a little work on the side and beat full-time investment professionals at their game.
Even more baffling are the stock-pickers who don’t even read company financial statements. It’s impossible to pick stocks well without examining financial statements and comparing their meaning to the stock’s current price. A quick test I have for those touting a stock is to see if they can quote any of the company’s major financial figures from memory.
Confidence is important in many areas of our lives, but overconfidence can hurt you financially. Mind the overconfidence gap.
So what you are saying that confidence is the most important part of investing and that will help me get rich, right?
ReplyDeleteI am curious how many folks would read your warning and interpret it to either think:
1) It doesn't apply to them, because they know what they are talking about
2) You need to be a confident investor
I think I got your message.
@Big Cajun Man: It's often the case that people who don't need a piece of advice pay attention, and the advice just bounces off those who need it. I'm sure that most people who are dangerously overconfident of their investing abilities are also confident that this post doesn't apply to them.
DeleteI've often found the same thing to be frustrating - the gap you mention. When people are arrogant and really good, I find it much easier to tolerate the arrogance.
ReplyDeleteHave you ever successfully talked down someone who is overconfident? I have a couple of friend who have this issue, but I don't know how to help them.
@John: Sometimes overconfidence takes the form of arrogance, but not always. I've known people who are superficially pleasant enough, but their technical overconfidence makes them difficult to work with.
DeleteI don't know that I've ever "talked down someone who is overconfident," but I've seen many cases where a smart young person joins my group assuming he or she (but usually he) will be the smartest person in the room. I've had the pleasure of working with many brilliant people over the years. Usually new young people figure out after a while that they're working with very smart people.
"It’s staggering that we often think we can do a little work on the side and beat full-time investment professionals at their game."
ReplyDeleteThis statement is kinda funny because, as data reveals, the greater majority of those same professionals a) don't beat each other and/or b) don't beat the aggregate market.
Thus, you can be highly confident that it's not that difficult to beat the majority of pros if you follow a non-complex, low fee strategy.
@SST: Right. As I said, you can't beat the pros at their game, but you can win by not playing their game. Low-fee strategies won't beat the majority of pros before their fees, but such strategies will beat them after they charge their fees. And since after-fees is the only way we get access to pros, the low-fee strategies are best for almost all people.
DeleteOver-confidence can apply to many of life's principles, I agree it can be a very bad trait to have when it comes to investing.
ReplyDelete