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Beware of Overconfidence

July 2, 2024 | Posted in: Insights, Wealth Strategies

Most of us are guilty of one or more of the destructive biases that researchers in the field of Behavioral Finance have identified. Perhaps the most dangerous is Overconfidence Bias which is a significant risk today given that we are enjoying a healthy economy and a stock market that is at all-time highs. Studies indicate that highly confident investors have a tendency to trade too often, take excessive risk, use imprudent levels of leverage, under diversify, disregard contradictory data, ignore expert advice, and make unsuccessful attempts to time markets, all of which can materially reduce returns.

How do we know that many investors are overconfident? The Financial Industry Regulatory Authority or FINRA tested the financial knowledge of a large number of individuals and then asked each person to assess his or her own financial acumen. Sixty-four percent rated their knowledge highly despite answering the majority of the test questions incorrectly. A recent paper published by MIT’s Sloan School also found that many individuals overestimate their financial knowledge leading them to reject objectively correct financial advice. To place a dimension on the problem, a study of members of the American Association of Individual Investors (AAII) found that they overestimated their actual returns by 3.4% per annum and overestimated their return relative to the average investor by 5.1%.

Perhaps the most important potential impact of Overconfidence Bias is susceptibility to investment fraud. Most of us would imagine that the likely victims of fraud are isolated, financially naive, frequently elderly, and often female. Quite the contrary, several studies found that victims are more often male, single, younger, well-educated, and financially literate. Moreover, many possessed significant net worth.