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Do you deliver better-than-average work at the office? Do you drive better than the average person on the road?
You likely answered ‘yes’ to both of those questions.
A fair amount of research finds that most people will almost always rate themselves as ‘above average’ on these issues.
In 2018, a study found that 65% of Americans consider themselves of above-average intelligence. A survey of 1 million high school students in 2005 reported that 70% believed they were above-average leaders. And a famous paper published back in 1981 discovered that 88% of American graduate students and 77% of Swedish graduate students rated themselves as better-than-average drivers.
Our positive illusions
Statistically speaking, it is evident that these responses can’t be accurate. By definition, a significant majority of any sample can’t be above average.
Humans, however, naturally believe they are better than they are. And, for the most part, this is not unhealthy. In a 2011 paper, researchers from the University of Amsterdam wrote:
“Mentally healthy people blissfully suffer from what is called positive illusions: they overestimate their abilities, as well as their control over events, and they underestimate their vulnerability to risk.”
However, this does come with its drawbacks. For example, surveys have found that as many as 88% of people use their mobile phones while driving, even though the risk is well known. One can assume that people do so anyway because they believe in their own superior driving abilities.
The money problem
Unfortunately, many people also overestimate their knowledge of investing and finance. They think they can make better decisions than the average person and beat the market.
This is not just among everyday investors. Professional fund managers have the same bias, even though they are unlikely to be correct.
Research over many decades has shown that most active managers don’t beat the market. The most recent S&P Indices vs Active (SPIVA) scorecard in the US shows that a little over 15% of US large-cap fund managers beat the S&P 500 over the past five years. Over ten years, less than 10% managed to outperform.
However, a study in 2006 found that 74% of fund managers consider themselves above average.
Underestimating risk
For individual investors, however, the risks can be significant. As a new paper about financial literacy in Saudi Arabia points out:
“Overconfidence in financial knowledge results in poor financial choices and ultimately leads to financial losses for individuals.”
The reality is that being too confident about our investment ability means we underestimate the risks we might be taking. When we are sure we are right, we don’t think enough about what might happen if we are wrong.
A clear recent example has been the crypto world, where many cryptocurrencies have imploded. Many people have lost a lot of money because the ‘investments’ they made into these tokens have become worthless.
Right place, right time
Unfortunately, overconfidence is highly prevalent in crypto. That is because it is so difficult to understand cryptocurrencies, what they do, and therefore why their prices go up or down.
The chances are that people who were just lucky to be in the right place at the time when everything was going up let themselves believe that they had been smart to invest. So, they took on more and more risk.
Unfortunately, getting caught up in the hype has left many with huge losses. Since they were too confident in what they thought they knew, they underestimated the risks.
And what happened next is a good lesson for every investor to learn.
To discuss your long-term investment strategy, speak to a professional.
Related: Loss Aversion and Lifestyle Creep: How Behaviour Influences Saving