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There are countless ways to run into trouble with your financial life, but the combination of overconfidence and inattention can be toxic.
Professor Ken French says, “Most investors are overconfident in their ability to identify opportunities in the market.” Those of us with the Y chromosome can be particularly susceptible to this malady.
The difficulty is magnified because you usually don’t realize that you’re overconfident, and therefore make investment decisions based on your built in biases.
Nothing within our evolutionary history prepares us for filtering information needed to make good financial decisions.
Overcoming Overconfidence Bias
Research by Professors Tetlock and Mellers at the University of Pennsylvania demonstrates that many trained professionals such as doctors, lawyers, and engineers display remarkable overconfidence when making forecasts about future events. Their research found that people in their study were 80% confident in their forecasts, but ultimately 60% wrong.
Investors often forecast trends and market prices based upon their own worldview. It’s difficult to talk people out of what they perceive to be logical. The result is what economists’ term “overconfidence bias” which is both pervasive and largely invisible to most investors.
The way that this overconfidence works its way into financial decisions is through the search for the “perfect” investment or the “optimal” portfolio allocation.
If you listen to many investment pundits, you’ll often hear the words “optimize” and “maximize” to describe what they believe is the overarching goal of investing. Given actual long-term financial market history and the difficulty of accurately forecasting the future, this is a terribly short-sighted objective.
Investors are overconfident because they fear uncertainty. However, life would be pretty boring without the unexpected, without the surprises. Remove the uncertainty and you eliminate risk. Without risk, you would have no expectation for above inflation investment returns. These premium returns are what’s needed to ultimately sustain your lifestyle throughout retirement.
Instead of trying in vain to eliminate or avoid uncertainty, learn to live with it and lean into it.
Indecision Is a Decision
Your financial life consists of things that you decide to do, and things you decide not to do. The word “decide” is a verb, but often things you don’t do are simply the result of neglect.
It’s easy to become distracted in our noisy world and the sheer amount of information available can add a complicating element to your decision making.
Money isn’t just a number on a page, but rather it’s a tool to help you accomplish things.
Thinking that a particular investment is going to solve everything in your life is foolish. Yet, many clients think that’s true. As author Morgan Housel says, “Money is a tool you can use, but if you’re not careful it will use you.”
The complexity that often comes with financial success can blur the path toward good decisions. When your financial life is simple, you have clarity, but with financial success comes more choices. When these choices become imponderable, inertia often is the end result. Nothing gets done.
It’s critical to understand that when you avoid making a decision, that in essence is the decision. Trying to decide for months or years about which estate attorney you want to use doesn’t move you closer to having an estate plan. Just thinking about making a decision isn’t the same thing as taking affirmative action.
Most financial research deals with investing, but the behavioral aspects of implementing financial decisions is where you can actually move the needle. Recognizing the nature of overconfidence and inattention in your financial life is critical. Start there.