When it comes to decision making, most people tend to have an unwarranted confidence in their own abilities.
In a piece of famous research conducted by Ola Svensson, 93% of Americans claimed to be better drivers than average. But it doesn’t take a lot to realise that this is a mathematical impossibility. The fact is many of us simply believe that we are better than we really are.
However, what has been shown to be true in relation to driving, can also be applied to other walks of life. In short, thinking we are better drivers than is really the case can clearly have dangerous consequences. Equally, overconfidence when investing can be dangerous for our wealth.
Imagine you are an investor who has just had a run of picking some winning shares or funds. You may conclude that the success is down to your investment skill. That may be the case, but it’s also possibly the result of luck. The problem is that in either case, whether through skill or luck, recent success may encourage you to take greater risks. While this could lead to greater profits, it’s just as likely to result in greater losses. So is the risk really worth it?
Research has shown overconfident investors not only take on more risk, but they also tend to trade more frequently, with a subsequent reduction in their returns. Over a six-year period, professors Barber and Odean carried out detailed research on more than 78,000 US brokerage accounts, analysing over three million trades. Specifically, they wanted to understand how investment returns differed for the 20% of investors who traded the most compared to the 20% who traded the least.
The results were truly shocking. The confident, frequent traders achieved returns of 11.4% a year compared to 18.5% a year for the less active traders. To put this into perspective, £1,000 invested at the beginning of the period would have grown to over £2,700 after six years for the active traders, compared to over £4,000 for the infrequent traders. Interestingly, the professors also found that women traded less frequently than men and consequently had better returns.
The real problem, especially when it comes to investing, is that the more overconfident we are, the less likely we are to see it. So next time you are about to trade, pause and ask yourself if you really are likely to know better than the market.
James Norton is a senior investment planner at investment firm Vanguard UK.