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The impact of overconfidence on investment decisions

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By Capital Partners Lifestyle

If you were to compare yourself to your friends, how would you rate your driving ability? Where would you be?

  1. Top 10%;
  2. Top 25%, but not the top 10%;
  3. Top half, but not in the top 25%;
  4. Bottom half, but not in the bottom 25%;
  5. Bottom half, but not the bottom 10%; or,
  6. Bottom 10%.

Statistically, more than 70% of people interviewed felt that they were in either the Top 10% or the Top 25%. Only 30% of all respondents placed themselves outside of the top 25% of all drivers.  Now, this study was of such size (hundreds of thousands of participants) that a statistician would expect the majority of answers to be spread across a normal distribution with the majority of answers falling in the middle ground and small outlying results in the extreme groups.

With this study, however, the results were severely skewed towards the extreme results on the positive side. The answer to this abnormal distribution is that as humans we are naturally overconfident. We overestimate the precision of our knowledge and we over estimate our level of ability.

It is a proven fact that the human trait of overconfidence can have a negative effect on your investment capital. The overconfident investor will trade more often (with less regard to the taxation and administrative costs) and diversify less.

Overconfidence = higher trading costs and worse tax treatment

An overconfident investor making speculative trades sells one stock (or group of stocks) and buys another stock (or group of stocks) because they think the new stock will outperform the original stock. The more actively that stock is turned over, the higher the transaction costs and the higher the level of tax payable.  These are both costs that need to be recovered through successful investment performance in order to break even.

Research from over 66,000 households in the US showed that the 20 percent of investors who traded most actively earned an average net annual return of 5.5% lower than that of the least active investors and that was before the negative tax effect!

Overconfidence = less diversification

If you knew you were going to make a fortune on say Woodside shares (or for that matter any other investment), why would you bother covering your bet with allocations to other shares? Indeed any other asset classes?

The answer of course lies in the fact that no person has been shown to consistently and reliably make investment decisions that outperform the market. If the Woodside price were to have moved in the opposite direction, without a diversified approach you could lose a large part of your investment capital. Due to this, the mantra of the successful investor is to diversify.

We are all poorly wired for investing. Overconfidence leads us to high levels of trading and low diversification. Both are surefire ways to erode our investment capital.

It is only through the disciplined approach of applying a course of action founded on evidence that we can make smarter decisions with our money. Capital Partners has been supporting Australians for over two decades. We’re the only CEFEX-certified firm in Western Australia, and we’d love to have a conversation about how we can help you find your true prosperity.

The information provided on this site is of a general nature only and may not be relevant to your particular circumstances. The circumstances of each investor are different and you should seek advice from a financial planner who can consider if these strategies and products are right for you.

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