Control your investment optimism

I recently ran into a cousin who had become a member of an online survey company and was trying to convince me to do the same. When I asked him how the company planned to make money, he came up with some mumbo jumbo about a proprietary business model and how the details were not to be shared as competitors could copy the model.


It reeked of a Ponzi scheme, a fraudulent investment plan wherein the illusion of a successful business model is created by using the money being brought in by new investors to pay off the earlier ones. My cousin was convinced it would put him on the road to riches; he was undoubtedly a victim of overconfidence.

Overconfidence or overoptimism
Overconfidence or overoptimism is a highly visible trait in everyday life as people exhibit great faith in their own physical and mental abilities. In fact, psychologists have performed several experiments over the years to conclude that people rate themselves very high on their positive personal characteristics. "Most people think they are smarter than average, better drivers than average, and indeed simply better people than average," states Tyler Cowen in the book Discover Your Inner Economist. Cowen also runs the world's most followed economics blog www.marginalrevolution.com.

This is the reason that we take on stronger opponents in contests, drive more recklessly, do not crosscheck facts, often ending up taking bigger risks than we should and losing more money and self-esteem than we need to. This is also the reason that gymnasiums find it easy to drive up their revenues. As Cowen points out, "Most people overestimate how often will they visit the gym. They buy gym memberships that make sense only if they are exercise hounds, and, of course, many of them are not."

It's easy to cross over from confidence to overconfidence because there is a very fine line dividing the two. While the former is a pragmatic assessment of one's ability, the latter is an unrealistic, subjective opinion about one's prowess.

Overconfidence in finances
This trait filters into the investing world as well. People are overconfident about their ability to make accurate estimates and believe they will never be victims of financial fraud, especially if they've had no negative experience in the past. This is the reason they fail to ask the obvious questions-and end up losing money.

Investors are overconfident that they can predict the future and often find themselves saddled with losing stocks or poor performing mutual funds. This is also the reason they stick to losing assets for longer than they should. They also go on to trade more frequently and, subsequently, perform the worst. This has even been proved by a research conducted by American professors Brad Barber and Terrance Odean, who studied 35,000 investor brokerage accounts and found that most stock market investors are overconfident.

They asked the investors about the kind of return they expected from their portfolios over the next 12 months. They also asked the investors about the returns they expected from the stock market during the same period. Most people believed that their investments would do better than the overall market, with men more confident than women. They expected their investments to beat the market by 2.8%, compared with 2.1%. in case of women. The actual results were exactly the opposite of what the investors expected. Women underperformed the broader market by 1.72% per year, whereas men underperformed the broader market by 2.65% per year.