Do you play recreational tennis or golf? Would you bet your retirement savings you could beat Roger Federer or Tiger Woods? Of course you wouldn’t. In most areas of your life, you objectively assess your skill level, and make intelligent decisions about the outcome of your planned activities.
Overconfidence is common in investing. Unfortunately, many people abandon any pretense of objectivity when it comes to investing. They are overly confident in their ability to achieve returns that will “beat the market.” Such investors are not alone. One 2006 study, “Behaving Badly,” by James Montier, surveyed 300 professional mutual fund managers. Nearly 75 percent of them thought they were above average at their jobs. Very few, if any, believed they were below average. Obviously, only 50 percent of this group could, by definition, be above average. In reality, the high opinion many of these professional mutual fund managers had of their investing skills was irrational and unwarranted.
Another study, “Volume, Volatility, Price and Profit: When All Traders Are Above Average,” authored by Terrance Odean and published in The Journal of Finance in 1998, examined what happens in financial markets when investors are overconfident. It found that overconfident investors expend too many resources on information acquisition and trade too much. The study concluded that the pursuit of information deemed necessary to increase returns causes overconfident traders to “fare less well than passive traders.”
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