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Investor Psychology

Overconfidence Game

Investors tend to overestimate the accuracy of their information and their skill in using it.

You’re really not as good an investor as you think you are. Please don’t turn the page -- it’s nothing personal. We all tend to overestimate our abilities. But here’s the good news: A simple reality check can improve your performance.

Overconfidence is part of the human condition. One study found that 93% of us think we’re above-average drivers. Another discovered that 25% of high school seniors rated themselves among the top 1% in their ability to get along well with others. Moreover, we tend to attribute our successes to skill and our failures to bad luck. (Want to test your confidence? Take our quiz.)

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Psychologists think this inflated opinion of our own abilities isn’t so much self-delusion as it is a coping mechanism. If we didn’t feel sure of ourselves, we might not be motivated to attempt things that have an uncertain outcome, such as starting a new business or asking someone for a date. So overconfidence often works to our advantage.

Lower returns. But it hurts us with investing. A landmark study showed that overconfidence in our investing abilities leads us, on average, to trade too often and hurt our returns. The study was conducted by Terrance Odean, a professor of banking and finance at the University of California at Berkeley. He summarizes the results this way: “People think they know more than they do, and it costs them.”

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Ironically, research shows that the more difficult a task is, the more unrealistic we are that we can handle it -- and investing is a tough job. Investors tend to overestimate both the accuracy of their information and their skill in using it, says John Nofsinger, professor of finance at Washington State University and author of The Psychology of Investing (Prentice Hall, $44).

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Overconfidence is particularly a problem with beginning investors, Odean says. As we gain experience (and make some painful mistakes), we become more skillful investors -- or at least better able to recognize our true abilities. In research-speak, subjects whose expectations match their abilities are well calibrated.

But becoming well calibrated can be a slow process. To learn quickly, we need immediate and clear feedback, which the stock market rarely delivers. The markets may be based on real events, but prices are whipsawed by fear, greed and rumors.

Still, we can learn. Take a break, go back to our Web site and take our second confidence quiz.

See? You did better. Not only are you equipped with new knowledge regarding overconfidence, but you also have some experience in taking that particular test. Knowledge and experience add up to better results.

Set benchmarks. How can you use these epiphanies about overconfidence to improve the performance of your investments? One way to get serious feedback is to set some benchmarks.

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Let me suggest a trick I’ve tried with my own portfolio. I used to buy index funds and treat them as benchmarks to test my judgment in picking actively managed funds. True, I could have just checked the indexes’ performance without buying the funds, but I found that having some skin in the index game really focused my attention.

When my actively managed funds didn’t beat the indexes for long periods (at least a year), I realized I had made bad, and probably overconfident, decisions. This realization led me to buy and sell less often, make more-thoughtful choices and earn higher returns.

And if you find beating index funds impossible, it could be time to admit that you have too much faith in your abilities and simply invest in indexes. After all, most actively managed funds don’t beat their benchmarks. You’ll be well calibrated and, most important, richer.

Kiplinger’s is partnering with Nightly Business Report on the “Your Mind & Your Money” series, funding for which is provided by the Finra Investor Education Foundation. For companion video reports, tune in to NBR on your local PBS channel Feb. 8, 15 and 22.

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