If you’re like most people, you probably assume you know more than you think you do, even if you don’t realize it.
That false sense of security allows us to be decisive in the face of great uncertainties.
But when it comes to investing, that can backfire, according to Phil Fernbach, a professor of marketing and the director of the Center for Research on Consumer Financial Decision Making at the University of Colorado.
A new academic paper Fernbach co-authored with Daniel Walters, a professor of marketing and the director at the Marketing Insights Lab at INSEAD, sets out to find out why.
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Their conclusion: A combination of biased memories and overconfident assumptions is likely sabotaging individual investors’ performance.
“Overconfidence as an investor or trader is really, really dangerous, because you can get yourself in a lot of trouble,” Fernbach said.
Why your memories are likely distorted
When it comes to your past investment performance, your memory is likely to lead you astray.
“If I ask you, ‘How well did your past investments do?,’ you’re going to remember it as being better than it actually was,” Fernbach said.
That supports a belief that you’re good at investing or trading despite evidence to the contrary, he said.
Generally, people tend to remember the good times and forget the bad times. This contributes to a positive self-image.
That overly rosy view of the past contributes to overconfidence.
Overconfidence and investment decisions
When it comes to investing, in particular, too much confidence is not necessarily a good thing.
“If you don’t have an accurate view of the data, then you’re going to have an inflated sense of your own capabilities,” Fernbach said.
Overconfidence tends to contribute to higher trading frequency. Yet previous research has shown that the more trading an investor does, the less likely they are to be successful compared to a buy-and-hold strategy.
To be sure, investing requires a certain amount of trading, Fernbach said. For example, it makes sense to manage risks by rebalancing periodically. Investors probably also want to update their portfolios by adding new names and parting with old ones that no longer have good prospects.
But people tend to get into trouble when they fuss with their portfolios too much, he said.
If stocks are going up, they have a tendency to want to buy. Conversely, if everything is going down, they tend to want to sell.
“That type of reactive trading is really bad, because it leads to a lot of selling at the bottom and buying at the top,” Fernbach said.
Having a buy-and-hold approach to passive investments like index funds tends to perform better over time. But in a bull market, when people can trade in and out of strategies and still have gains, the performance gap may not be as obvious.
“At some point, the bull market ends and a lot of these swing traders, day traders find out that it’s not so easy to beat the market,” Fernbach said.
What to do before you invest
If you’re like many investors, you’re probably not aware of how a false sense of security could be leading you astray.
There is a way to combat this, according to Fernbach.
Before you make a move, look at your past performance. Based on the research, that tends to help give people a reality check as to their actual performance.
“They remember the winners as being better than they were,” Fernbach said. “They remember the losers as not being quite as bad as they were.
“All of those things can be eliminated just by looking at the data, looking at your actual past performance,” he added.
The research is based on several studies of people who were actively investing from 2018 to 2020, typically with at least $1,000 in the market and at least two individual stock holdings.