Previously, we discussed overconfidence and its dangers when it comes to investing and making financial decisions. In this post, we want to talk about some fairly simple things you can do to combat overconfidence.
One of the best therapies for overconfidence is feedback. In a nutshell, feedback allows you to compare what you thought would happen with what actually happened. In some cases, life can give us feedback immediately. For example, you touch a hot stove, you get burned—quick feedback.
The world of sports can provide immediate feedback as well. In basketball, when you take a shot, you expect to make the shot. The good news (and the bad news, perhaps) is that you get feedback right away: The shot goes in or it doesn’t. This feedback is an important part of the calibration process. The goal of calibration, over time, is to shrink the perception gap – the gap between your perception of reality and actual reality. Take enough shots in basketball, and eventually you will probably become well calibrated regarding your basketball skills (or in deep and obvious denial). The gap between your perception of your basketball skills, and your actual basketball skills, should shrink over time.
Based on my observations, the root of overconfidence in the financial realm is a result of people being poorly calibrated. In other words, there is a big gap between people’s perception of their stock picking and market timing skills and their actual stock picking and market timing skills. I think this stems from a lack of feedback due to people generally being really bad financial record keepers with incredibly selective memories. We have a mind like a bear trap when it comes to remembering our winners, but have acute amnesia when it comes to our losers.
Fortunately, there’s hope if you use my incredibly inexpensive feedback mechanism–a pen and pad of paper. That’s all you need. Then, simply write down your predictions and feelings regarding the markets or a particular stock at any given time. Most importantly, write down your predictions when you feel most strongly about something, as that is probably when you are most susceptible to a case of overconfidence. Then go back and regularly compare what you wrote down with what actually happened. Over time, I am fairly confident (okay, hold the snarky overconfidence comments!) that this will be a humbling and eye-opening experience. Over time, this feedback will help you to become better calibrated when it comes to your financial decisions.
Unfortunately, there is no cure for overconfidence or any of these natural tendencies. They are deeply ingrained in us and are part of what it means to be human. The best you can hope for is to put on some constraints to manage yourself and keep overconfidence at bay. As a substitute for the bad investment behaviors often caused by overconfidence, try adhering to less glamorous, but far more reliable, time-tested principles of investing, such as the boring but effective diversification, dollar-cost averaging and rebalancing.
The next time that a friend or neighbor confidently tells you where the market is headed or that Facebook is a no-brainer investment, you can politely nod, knowing that you are probably witnessing a real-life occurrence of overconfidence. Perhaps, as a friend, you could suggest that he or she buy a pen and a pad of paper.