You’ve got this. Or do you?
Don’t let overconfidence undermine your financial health
Overconfidence. It’s what leads people to under-estimate traffic or overestimate how much they can fit into a day. It’s also what led some of history’s greatest leaders to their downfall. But what does it mean for you and your financial goals?
In simple terms, overconfidence is our tendency to overestimate what we know or what we’re capable of.
It usually trips us up in small ways, often giving us blind spots about individual traits, like how quickly we can complete a list of chores or how our navigational skills compare to a GPS.
Overconfidence has been the subject of extensive scholarly scrutiny, studies and surveys, like one that found that 93% of Americans believe they are above average drivers.1 And another from Harvard found students believed they could predict daily egg production in the U.S. with 98% accuracy but were only accurate 60% of the time.
Overconfidence can lead people to:
- Focus on short-term wins rather than long-term goals
- Gamble and make bets
- Enjoy placing trades or making other financial transactions frequently
- Think they’ve found the next “big thing”
- Stray from their established financial plan
From 1997 to 2016, missing just 10 of the market’s best days would cut an investor’s return nearly in half compared to someone who stayed invested the whole time. Source: JP Morgan
IS OVERCONFIDENCE OVERTAKING YOUR FINANCIAL SUCCESS?
When it comes to money and the markets, overconfidence tends to create the illusion that past success was the result of intrinsic luck. It’s why overconfident investors frequently believe they can time the market, despite the high rate of failure for those who try.
Overconfidence can also lead us to underestimate the possibility of a costly life event down the road, such as an illness, divorce or disability. According to AARP, a quarter of people age 45 and over are not financially prepared should they suddenly need long-term care for an indefinite period of time.
Other times we overestimate how long we have to save for retirement or our long-term goals. Young professionals might put off making contributions to their 401(k) and thereby forfeit the benefits of compounding. Or, individuals in or nearing retirement or our long-term goals. Young professionals might put off making contributions to their 401(k) and thereby forfeit the benefits of compounding. Or, individuals in or nearing retirement
When overconfidence creeps into financial planning...
- You might take past successes – due to luck or external factors like broader market trends to mean that you’ll be successful with future selections.
- You might eat away any gains with high transaction costs and taxes from regular buying and selling.
- You might have loose ends in your estate plan.
- You may not plan for the possibility of long-term care.
- You might miss or ignore signals and external advice that suggest making a change.
Overconfidence can undermine the success of a long-term financial plan. Fortunately, it doesn’t have to be the downfall of yours. Start by taking a more objective look at past successes. How much was due to your actions? How much was due to external circumstance? How much was luck? How much was good planning?
Apply this lens of objectivity to the future, as well. If you have instincts regarding a certain investment, consider what exactly is motivating those feelings. Objective research and information or a one-time stroke of luck?
The reality is that staying objective can be a challenge if your voice is the only one in the room. That’s why I work closely with individuals like you to provide the information, resources and experienced insight you need to make sound decisions regarding your wealth and future.
While believing you can always beat traffic likely won’t have dire consequences, overconfidence can sabotage your decisions when it comes to more important and complex matters. By taking steps to counteract it, we can help keep you just the right amount of confident when it comes to achieving your goals.
THINK BEFORE YOU ACT
To help you keep overconfidence from derailing your financial plan:
- Remember that past performance doesn’t guarantee future results.
- Consider the real source of your gut feelings. Does data or external research back you up?
- Take a look at the fee and tax consequences of your investment activity. Do the gains outweigh those costs on a consistent basis?
- Account for the unexpected in your financial plan, such as an illness or disability.
- Seek out the perspectives of people whose beliefs differ from your own and professionals with specialized expertise.
1 Ola Svenson, ‘Are We Less Risky and More Skillful than Our Fellow Drivers?’, Acta Psychologica, 47 (1981), 143–51