Investors are usually overconfident about their abilities to complete difficult tasks successfully, such as picking winning stocks. They believe their knowledge is more accurate than it really is and that their forecasts are more precise than their experience should validate. This “the ego trap” is pervasive.
One factor that contributes to overconfidence is called the illusion of knowledge, which occurs when more information is available. Increased levels of information do not necessarily lead to greater knowledge because many investors may not have the experience or skills to interpret this information. The internet fosters the illusion of knowledge because there is much information, but little wisdom.
Overconfidence is exhibited by investors’ expectations of their investment performance. For example, survey of individual investors asked what they thought the stock market return would be during the next 12 months, the average answer was 10.3%. When asked what return they expected to earn on their own portfolios, the average response was 11.7%. On average, investors expect to earn an above average return. Indeed, overconfident investors believe more strongly in their valuation of a stock, and concern themselves less about the beliefs of others. Unfortunately, the data suggests otherwise—without professional advice, individual investors underperform.
What investment behaviors are caused by overconfidence? Excessive trading and risk taking. Overconfident investors trade too much. If you have confidence in your investment knowledge and skills, then you want to use them. That usually entails making decisions to trade. Indeed, studies show that higher trading contributes to poor returns.
For example, using a sample of nearly 38,000 households through a large discount brokerage firm, one study sorted investors into five groups by their level of trading turnover. The lowest turnover group had a 2.4% turnover rate per year. The highest turnover group experienced an average annual turnover of more than 250% per year. A turnover of 250% means that if you own 10 stocks at the beginning of the year, then you would sell all ten stocks, buy ten more, sell those, buy ten more, and finally replace five more stock by the end of the year. The highest turnover group experienced a 7.1% lower average return than the lowest turnover investors.
It is not just commission costs that eat away the returns of excessive trading. Overconfident investors also buying the wrong stocks. The study shows that the stocks that investors sold earned 2.6% during the following four months. In contrast, the stocks investors replaced them with earned only 0.11%. In the year following the trades, stocks that had been sold outperformed stocks purchased by 5.8%.
Also, overconfident investors take more risk because they feel that their skills and oversight manage those risks. The overconfident investors tend to have riskier portfolios because they are less diversified (own fewer stocks), hold higher risk stocks (as measured by beta and volatility), own smaller firms, and more likely buy initial public offerings. Since they take more risk, they should earn a higher return. Unfortunately, they earn a lower return.
Investors derive their opinions based on their beliefs about the accuracy of the information they have obtained and their ability to interpret it. This overconfidence causes investors to trade too much and to take too much risk. It increases trading because it causes investors to be too certain about their opinions. That is, investors believe they can predict winners better than others. As a consequence, investors pay too much in commissions, pay too much in taxes, and are susceptible to big losses due to a lack of diversification.
John Nofsinger, Ph.D.
Seward Chair of International Finance, University of Alaska Anchorage
Author, The Psychology of Investing, 5e
The investment philosophy at APCM is to focus on what you can control, staying diversified and keeping expenses low. Our disciplined strategy is to construct efficient, diversified portfolios using state of the art optimization software coupled with solid fundamental research and experience. We select the best low cost index or exchange-traded funds to gain exposure to the various equity asset classes. We minimize expenses, keep turnover down and execute trading efficiently. We are the trusted experts to manage your portfolio.