Fifteen months ago, I was asked to write a short article for the local newspaper. At the time I wrote it, I thought it was for the school newspaper. After it was published, I found out that I’d written it for the local newspaper, so I suppose it had a slightly broader audience. Apparently, the department takes turns writing articles for the paper. It’s my turn and below is what I drafted on the spur of the moment this evening (as I’d forgotten that the due date was noon today).
There’s a field of economic research—behavioral economics—where psychology plays a major role in developing ideas about how and why people behave the way they do. We’re learning some fascinating insights into how people act in ways that upend our beliefs of human rationality. I’ll show you a couple of examples of how our behavioral tendencies cause us to act irrationally, even in the realm of finance, and offer up a couple of suggestions for how to overcome our inherent rational shortcomings.
A common example of a behavioral bias is people’s tendency for overconfidence. I’m sure you know someone who has unrealistically positive views of their own skills, knowledge and abilities. That might even describe you. For example, how would you answer the following questions:
“Are you a good driver? Compared to other drivers you see on the road, are you above average, average, or below average?”
One study noted that 82% of sampled college students rated themselves above average! Obviously, many are wrong because they are overconfident in their skills. While being overconfident behind the wheel might not significantly impact your daily life, similar overconfidence issues can affect many things, including your financial future.
Moreover, this is not only a characteristic of the young. It’s commonly understood that most new businesses fail; yet when surveyed about their chances, many new business owners thought they had a 70% chance of success, and only 39% thought any business like theirs would be as likely to succeed!
Perhaps unsurprisingly, this overconfidence stretches even into the stock market. People who are overconfident tend to trade more actively in their investment accounts. Men tend to feel more overconfident in their ability to make investment decisions than women, resulting in more frequent trading and higher turnover for male investors than female. An examination of trading patterns of 39,000 household brokerage accounts noted that men (and single men particularly) were much more likely to trade and had 50% more turnover in their investment holdings than women, resulting in much higher expenses and significantly lower net returns.
Furthermore, overconfident investors believe they are better evaluators of new information and trade more aggressively. Except that they’re not usually as good as they think…the research on these more active traders indicates that they often pick the underperforming stocks. To quote a recent book on it, “Overconfidence-based trading is hazardous when it comes to accumulating wealth.”
If there’s a takeaway from the behavioral finance research I teach, it’s that we’re not as good at stock picking as we want to believe. It’s probably worth remembering that before pulling the trigger on the next stock tip you hear. Instead, we should usually invest in broad market index funds and do so for the long haul. That’s one way to avoid making overconfident trading decisions. Finally, it’s worth remembering that while behavioral biases are present in a vast range of our daily decisions, knowing how they impact our actions can help us overcome them.