Money is not a client of any investment adviser featured on this page. The information provided on this page is for educational purposes only and is not intended as investment advice. Money does not offer advisory services.
If you made it out of 2022 unscathed despite it being the worst year for the stock market since 2008, you may be feeling smug about your investing skills. You're not alone in cheering if you've ever picked a stock that soared or patted yourself on the back for jumping on a hot trend, like meme stocks or crypto, at precisely the right time.
But don't get too cocky.
"There's a lot of overconfidence bias out there amongst investors," says Marlena Lee, head of investment solutions at Dimensional Fund Advisors. "Pretty much anyone who thinks that they can pick an individual stock, or pick up an investment trend or fad or time the market, I think, is very likely susceptible to overconfidence."
If an investor has gotten lucky, it can be hard to distinguish that random good fortune from skill, she adds. There's a lot of evidence that even Wall Street professionals can't reliably beat the markets — and, sorry, but chances are low that you know more than they do.
While many investors implement a long-term "buy and hold" approach, if you're tempted to try to time the market, you may want to think again.
The psychology behind overconfidence bias
As humans, if we see someone slip and fall, we tend to attribute the mistake to them, says Dan Egan, vice president of behavioral finance and investing at Betterment. (As in, "Oh, they must just be a clumsy person.") But when we ourselves make the same mistake, we tend to attribute it to some outside factor, like the ground being slick.
"Our minds are very good at protecting and stroking our own egos,” Egan says.
This applies to investing, as well. If an investor buys an asset before it soars, they'll say "it's not that I got lucky — I was skillful," Egan adds. But if the price drops, there's a good chance they'll blame it on bad luck.
There also seems to be a misalignment between how much some investors think they know and how much they actually know.
A report from the Financial Industry Regulatory Authority (FINRA) published late last year shows how wrong some investors are about how much they know about investing. FINRA asked respondents to take a 10-question quiz to assess their investing knowledge, and while younger investors were slightly more likely than older respondents to say they feel comfortable making investment decisions — and just as likely as their older counterparts to rate themselves highly on their investing knowledge — they also answered more questions incorrectly.
"These findings suggest that many younger investors are not simply uninformed, but potentially misinformed," the report reads.
The risks of overconfidence bias
Thinking you know more than you do has its detriments in a lot cases, but when it comes to investing, that can lead to actually losing money.
If you're overconfident, then you might extrapolate past returns into the future, Lee says. For instance, you may invest in assets, like stocks, that did well last year with the assumption that they will continue to do well moving forward... even though there's not a lot of proof it's a good strategy.
Another risk is that you may trade too much, she says. That can be costly for your portfolio in a number of ways (tax implications, for one).
But overall, acting on your overconfidence means that you likely won't be invested in a well-diversified portfolio that's aligned with your goals, like saving for a house or retirement — and that's really how most investors are best served, Lee says.
Reducing your overconfidence bias
Risk is an inherent part of investing. But Lee says it's important to have a systematic approach and avoid letting overconfidence lead you down a path where you're frequently taking unrewarded risks, like being too concentrated in one area of the market or trading too often.
It's very hard to plan for a goal like retirement if you're adding in a lot of noise by chasing an individual stock or market trend, she adds.
"That's not the type of risk that investors should be taking because it's not rewarded, but overconfidence can lead them to think that they can improve their outcomes by engaging in more speculative investments," Lee says.
Egan says a lot of avoiding this comes down to being a little less certain about things you feel really sure about. That way, if you do feel the need to make a change to your portfolio, you'll ideally make one that's smaller than you otherwise would.
For example, if you think the financial markets are in for another rough year, you might be tempted to move entirely to cash. But moving a smaller amount, like 10%, may cause less harm in the future. (A caveat: We're talking about investors who are tempted to constantly adjust their investment portfolio and need a way to limit themselves; as Money has previously reported, your best move when markets get tough is likely to stay invested.)
If you really have a hard time not acting on your confidence, test yourself.
Egan recommends keeping a record of some of your predictions and how they pan out. For example, if you believe that the Federal Reserve will raise interest rates at its next meeting and thus the stock market will sink, write down how much you think the market will fall and how confident you are that it will happen.
Then, later, look at the results.
“What you’ll probably find happening is that you get very good at being calibrated," he says. “Setting up those feedback loops about how often you were right or wrong with those things, actually gives you a better gut sense of how strongly should [you] implement this view in [your] portfolio.”