You’re really not as good an investor as you think you are. Please don’t turn the page — it’s nothing personal. We all tend to overestimate our abilities. Overconfidence is part of the human condition. Moreover, we tend to attribute our successes to skill and our failures to bad luck. (Want to test your confidence? Go to kiplinger.com/reports/investor-psychology and take the first of two quizzes.)
Psychologists think this inflated opinion of our own abilities isn’t so much self-delusion as it is a coping mechanism. If we didn’t feel sure of ourselves, we might not be motivated to attempt things that have an uncertain outcome, such as starting a new business or asking someone for a date. So overconfidence often works to our advantage.
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But not when it comes to investing, particularly with beginning investors, says Terrance Odean, a professor of banking and finance at the University of California at Berkeley. As we gain experience (and make some painful mistakes), we become more skillful investors — or at least better able to recognize our true abilities. In research-speak, subjects whose expectations match their abilities are well-calibrated.
But becoming well-calibrated can be a slow process. To learn quickly, we need immediate and clear feedback, which the stock market rarely delivers. The markets may be based on real events, but prices are whipsawed by fear, greed and rumors.
Let me suggest a trick I’ve tried with my own portfolio. I used to buy index funds and treat them as benchmarks to test my judgment in picking actively managed funds. True, I could have just checked the indexes’ performance without buying the funds, but I found that having some skin in the index game really focused my attention.
When my actively managed funds didn’t beat the indexes for long periods (at least a year), I realized I had made bad, and probably overconfident, decisions. This realization led me to buy and sell less often, make more thoughtful choices and earn higher returns.
And if you find beating index funds impossible, it could be time to admit that you have too much faith in your abilities and simply invest in indexes. After all, most actively managed funds don’t beat their benchmarks. You’ll be well-calibrated and, most important, richer.
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