Why Investors Do The Crazy Things They Do – Concept 6 Overconfidence

imagesThis is the sixth article in this series where I discussed a concept called behavioral finance. It’s a relatively new field that tries to combine behavioral psychology theory and economics and finance to explain why people make irrational financial decisions.

If you’ve been reading the previous articles, more than likely you have identified some of these behaviors that negatively influence your investment decisions. Maybe several!

So far we’ve covered 5 Concepts: Anchoring, Mental AccountingConfirmation and Hindsight Biases, The Gambler’s Fallacy and Herd Behavior.

Concept 6. Overconfidence
Overconfidence is overly positive assessment of your own knowledge or your control over a situation. In my 20 years as an investment professional, I’ve seen this concept really hurt investors. There’s a big difference between confidence and overconfidence.

Confidence would be thinking that you have picked the right investments for your portfolio. Overconfidence would be thinking they are the right investments and that what you select will remain the best indefinitely. I’ve seen investors with stocks they’ve owned for many years. Obviously things change with some of these firms, but investors still believe that they are great investments (because they picked them) regardless if the fundamentals.

How to Avoid Overconfidence
Keep in mind that professional money managers, with all their research and experience, still have trouble beating the markets. The investment and economic environment are constantly changing presenting a whole new set of variables to interpret. Overconfidence can change to humiliation in one trade.

Just a couple more concepts to go in this series.  Don’t miss the rest of the series of articles, click here for a free subscription and have them in your email inbox every Friday morning!