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You probably answered yes. If you asked a room of people, an overwhelming majority will answer the same. This is as the “illusionary superiority” [1]. While it is normal for us as people to overestimate our own abilities, this can be disastrous when it comes to our financial health. People who are overconfident will tend to trade more, follow financial media and herd mentality, and ignore lessons from previous mistakes.
Trading too much will cause a drag on portfolio performance. Especially when we consider things such as capital gains taxes, brokerage fees, and other needless expenses. Overconfidence will lead investors to think they can beat the market. This would not be a problem until you look at the statistics. Most individual investors that actively traded underperformed the market. This is before the other expenses were accounted for. Terrance Odean, a professor of banking and finance at the Haas School of Business at the University of California, Berkeley, asked the question “Do Investors Trade Too Much?” His study concluded that some investors indeed traded too much. Some investors traded even when expected gains were not sufficient enough to offset trading costs[2]. Disastrous results indeed. Needless to say that the time and money investors spent on trading could be better spent.
Another problem for active investors is that the market itself is quite efficient. This is especially a problem for investors who happen to follow the financial media. Information is now spread across the world in split seconds with the invention of the internet. Due to this fact, investors should not expect to be able to beat the market with publicly available information. Odean cited in his study that investors have a tendency to be the last people who buy when stocks are high and are among the panic-stricken individuals selling in disgust once they can't take the pain anymore[3]. Investors were effectively buying high and selling low. With the number of investors in the market and the instantaneousness of the internet, how can you expect to be ahead of the curve by reading financial media? Even if market inefficiencies did exist, the very act of investors trying to manipulate them would cause these strategies to self-destruct. If you knew a stock would go up in the future, why wait until then to trade when you can trade now? In his famous book, A Random Walk Down Wall Street, Burton Malkiel famously writes that “the ‘January effect’ is more likely to occur on the previous Thanksgiving[4]." The odds of beating the market by actively trading stocks will be nearly impossible. Yet the overconfident will continue to listen to the media noise and keep the printing presses well running.
Another financially fatal flaw in most investors is having a high degree of confirmation bias[5]. This is when investors tend to heavily attribute their past successful trades to skill rather than to luck. Likewise, they will dismiss past mistakes as bad luck without taking personal responsibility. Confirmation bias will lead investors to believe they can predict the stock market. Another shocking fact is that most inexperienced investors do not even know their past portfolio performance. Markus Glaser and Martin Weber discovered this in their study “Why Inexperienced Investors Do Not Learn: They Don’t Know Their Past Portfolio Performance.” They concluded that even investors who were able to give a correct estimate of their past performance were unable to outperform the market in future periods. Illusionary superiority shows up in their study as investors tended to overrate themselves once again[6]. Unsurprisingly, no correlation between confidence and actual performance were shown to exist. Do people really not know their past performance or are they reluctant to admit how badly they have done? Either way, the evidence of underperformance is clear.
These results were not limited to individual investors. The study, “Too Many Cooks Spoil the Profits: Investment Club Performance” by Barber and Odean, found that even investment clubs lagged behind. This is even before transaction costs are considered. Figure 1 shows just how badly the average investment club falls below market returns. Remarkably, the average investment club did worse than the average individual investor.
Figure 1: Barber, Brad M., and Odean Terrance. “Too Many Cooks Spoil the Profits: Investment Club Performance.” Financial Analysts Journal. (January/February 2000). 21.
We again see the dangers of actively trading as the study also concluded that frequent trading lowers returns[7]. We believe Barber and Odean summarized their findings nicely when they concluded.
Investment clubs serve many useful functions: They encourage savings. They educate their members about financial markets. They foster friendships and social ties. They entertain. Unfortunately, their investments do not beat the market.[8]
Perhaps investment clubs harbor a financially deadly “groupthink” mentality? Perhaps this is a matter of overconfidence of allowing your fellow friends to help guide you in your investment decisions? Either way, the results do not lie.
So how do you get the best returns for your money? In this article we have shown the dangers of overconfidence in trying to beat the market. The best answer for this is to make low-cost, no-load index funds the core of your financial investments. Don’t think of it as “settling for average” but rest easy knowing that you are beating most investors, managers, and investment clubs at a fraction of the cost – and with a lot less stress!
Read More:
“Boys Will Be Boys: Gender, Overconfidence, and Common Stock Investment.”
By Barber, Brad M. and Odean, Terrance.
https://faculty.haas.berkeley.edu/odean/papers/gender/BoysWillBeBoys.pdf
“Don’t Be Overconfident in Investing.” By Swedroe, Larry E.
http://www.cbsnews.com/news/dont-be-overconfident-in-investing/
“How Overconfidence Hurts Investors.”
By Swedroe, Larry E.
http://www.cbsnews.com/news/how-overconfidence-hurts-investors/
“Patterns of Investment Strategy and Behavior Among Individual Investors.”
By Lease, Ronald C., Lewellen, Wilbur G., and Schlarbaum, Gary G.
http://www.jstor.org/stable/2352539
The Quest for Alpha by Swedroe, Larry E.
“Unskilled and Unaware of it: How Difficulties in Recognizing One’s Own Incompetence Lead to Inflated Self-Assessments.”
By Dunning, David, and Kruger, Justin.
http://mastercodeprofessional.com/library_files/Kruger-Dunning---Unskilled_and_Unaware_of_It_%282009%29.pdf
Sources:
[1] https://en.wikipedia.org/wiki/Illusory_superiority
[2] Odean, Terrance. “Do Investors Trade Too Much?” The American Economic Review 89.5 (December 1999): 1279-1297. Web. July 2015. (Makiel)
[3] Odean, Terrance. “Do Investors Trade Too Much?” The American Economic Review 89.5 (December 1999): 1279-1297. Web. July 2015. (Makiel)
[4] Makiel, Burton. A Random Walk Down Wall Street. New York: W. W. Norton & Company, 1973.
[5] https://en.wikipedia.org/wiki/Confirmation_bias
[6] Glaser, Markus, and Weber, Martin. “Why Inexperienced Investors Do Not Learn: They Do Not Know Their Past Portfolio Performance.” Finance Research Letters. 4(4). (2007). 203-216. Web. July 2015.
[7] Barber, Brad M., and Odean Terrance. “Too Many Cooks Spoil the Profits: Investment Club Performance.” Financial Analysts Journal. (January/February 2000). 17-25. Web. July 2015.
[8] Barber, Brad M., and Odean Terrance. “Too Many Cooks Spoil the Profits: Investment Club Performance.” Financial Analysts Journal. (January/February 2000). 24. Web. July 2015.