Confidence is an important quality for investors to have. Without it, they may second-guess their investment choices and harm their portfolio returns.
It’s possible, however, to have too much of a good thing because overconfidence can be just as damaging if it leads to mistakes.
“The problem with overconfidence is that it doesn’t last — as soon as things go wrong, human nature takes over,” says Aaron Klein, CEO of Riskalyze, an online risk analysis platform.
Klein says overconfidence creates a vicious cycle in which investors buy when they feel confident, sell when they get scared, miss the recovery and jump back in when the markets feel safe again.
But you can stop overconfidence if you recognize the signs and change your behavior.
Check your biases at the door. Two behavioral traps especially set up an investor for overconfidence: hindsight bias and extrapolation bias, says Erik Davidson, chief investment officer for Wells Fargo Private Bank in San Francisco.
[See: 9 Psychological Biases That Hurt Investors.]
“Much like our human predisposition toward nostalgia about the past, where we only remember the good times and gloss over the bad, investors likewise tend to take a nostalgic view of their past winners but forget about their past losing investments,” Davidson says. That’s hindsight bias.
This can lead to extrapolation bias, by creating the illusion that you can predict market performance accurately. This behavior can become more pronounced if your investments have charted significant gains recently.
“Just because you were right a few times doesn’t mean you’ll be right again,” says Jim Woods, an analyst at InvestorPlace.com, an online investing and financial news site.
Woods says overconfidence, especially the kind that doesn’t reflect reality, is “the sin you don’t want to be guilty of when putting your money at risk.”
Listening to your internal dialogue is an effective way to determine whether you’ve fallen into the overconfidence trap. Constantly telling yourself that a stock is going to make a comeback is “the kind of self-delusion you want to avoid at all costs,” he says.
Keep your emotions out of decisions. Certain emotions can drive overconfidence, prompting investors to take unnecessary risks.
Thomas Lowry, a financial advisor and president of Atlanta-based Georgia Wealth Advisors, says greed often plays a role.
“Investors see strong returns and they get greedy,” leading them to take on more risk, Lowry says.
These same investors will sell when the market is down, making it harder to turn a profit on their investments.
Lowry also has seen overconfidence lead investors to put too much money at risk and adopt an investment style that doesn’t reflect their personality.
“Overconfidence combined with a strong stock market can cause a moderate or conservative investor to act like an aggressive investor,” Lowry says. “An investor who’s moderate or conservative wants to keep money safe, but overconfidence may cause them to take more risks to chase higher returns.”
Klein says many investors make the mistake of basing their risk tolerance only on their age. He advises investors against assuming they can stomach a volatile portfolio because they’re young, or that they can’t because they’re older.
Allowing emotions to motivate investment decisions can affect your larger financial plan.
Marcy Keckler, vice president of financial advice strategy and a certified financial planner with Ameriprise Financial in Minneapolis, says investors shouldn’t lose sight of their long-term goals.
“While some of these behaviors may be gratifying now, they could impact your savings down the road,” Keckler says, by changing your portfolio’s trajectory all because of one impulsive mistake.
Keckler says emotion-driven mistakes often stem from periods of market volatility, but when dips occur, investors are best served by staying the course.
[See: 13 Ways to Take the Emotions Out of Investing.]
Learn to let go. Overconfidence can encourage you to hold on longer than you should when an investment tanks.
“One of the most critical mistakes investors make is not knowing how or when to take a loss,” Woods says. “Losses don’t feel good, but small losses are manageable — and inevitable.”
Woods says what hurts the most are the big losses, since they take longer to recover from. Knowing when to cut your losses, whether large or small, is critical.
Shelly-Ann Eweka, a financial advisor with TIAA in Denver, says mistakes happen, but how you recover matters most. She says investors must be willing to sell an investment at a loss if it’s dragging down the value of their portfolio. An even better strategy, Eweka says, is “to decide in advance at what point you’ll throw in the towel if it’s underperforming.”
While no one wants to lose money, you can use losses to offset some of your capital gains on other investments, thereby reducing your tax liability.
Think long term. “Whether it’s the result of overconfidence, or perhaps the opposite — nervousness, in many cases, people will try to time the stock market,” Keckler says.
That behavior, Keckler says, is dangerous and can produce losses if investors forgo their long-term objectives for the sake of potential short-term gains.
That’s supported by a 2016 Dalbar study of investor behavior, which found that the average equity mutual fund investor in 2015 underperformed the Standard and Poor’s 500 index by a margin of 3.66 percent. Those investors might have fared better if they had invested in a single index fund instead.
Eweka says the study’s results can be attributed to investors selling low and buying high as they try to predict market behavior, rather than riding out the ups and downs.
Overconfidence can mistakenly cause investors to think they have a greater ability to get in and out of the market at the right time than they actually do.
“That requires being right not once but at least twice,” Davidson says, asserting that nobody can consistently time the market.
[See: Avoid These 8 Rookie Investing Mistakes.]
Lowry says investors can curb their overconfident tendencies by creating a plan with both short- and long-term investment goals. “A plan with those goals in mind will keep you focused, regardless of whether the market is up or down,” he says.
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The Dangers of Being an Overconfident Investor originally appeared on usnews.com
