A normal human being walks around with a slight sense of optimism, confident that a drunk driver won’t smash into his car that day, that he doesn’t have a dread disease, that he will get what he wants for his birthday. There is nothing wrong with that, psychologists say: Our ability to forge ahead despite the constant real dangers we face helps us to plan, work, and accomplish. Depressed individuals who lack that mild optimism have a hard time just getting out of bed in the morning. However, this generally healthy attitude is not so well suited to working with the investment markets, because it leads many investors to a general state of overconfidence.
Behavioral psychologists say studies show that too many investors are overconfident in their own skills, thinking they can pick individual investments or mutual funds, or time when to buy and sell investments based on their forecasts of market movements. Such overconfidence leads investors to trade more frequently than they should. On average, frequent trading reduces returns, according to several studies of thousands of trading records of individual investors.
We don’t learn from mistakes
Studies have shown that it is not just that we remember our successes and forget our mistakes. Instead of forgetting mistakes, we remember them in a way that bolsters our feeling of confidence.
Psychologists call it the “heads I win, tails it’s chance” phenomenon, say Gary Belsky and Thomas Gilovich in their book, “Why Smart People Make Big Money Mistakes - And How to Correct Them”.
When something happens that confirms a decision or belief we have, we attribute this to our abilities. But when something happens that proves actions or beliefs wrong, we attribute that to an outside force we could not control. Both phenomena leave us confident in the future, the authors say: “A little better luck, or a little fine tuning, and the outcome will be much better the next time.”
Rational investors need to step back from this bias and realize that it is incredibly difficult to make accurate predictions about the market and make timed investment decision based on them. Instead of fighting the thousands of highly educated pros, and the millions of market participants in an effort to make the “right” trades, individuals instead should put together balanced portfolios of index funds and hold them long-term.
This article was written by an independent writer for Brewster Financial Planning LLC and is not intended as individualized legal or investment advice