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Behavioral Finance

Overconfidence Hurts Results: Lessons From the Pool

Don't let your ego run the show. Overconfidence can reduce your investment returns.

Articles by Dan Egan

By Dan Egan
Managing Director of Behavioral Finance & Investing, Betterment  |  Published: August 14, 2013

Higher levels of trading are linked to lower returns, research shows.

Don't let marketing push you into doing something that's not the smart thing.

Every other morning, I go to my local pool for lap swim before going into work. There are three lanes: slow, medium and fast.  Which lane do you think is the fastest? Turns out it’s not the fast lane.

This is because people chose the label they want applied to themselves — e.g., fast — regardless of whether it’s true. The other day I counted nine people in the fast lane and three in the medium lane, which means the latter was actually the place to get the better workout.

These skewed numbers reflect our natural desire to feel like we’re in same lane with the top performers. It makes us feel good to believe we’re in an elite category when in fact we might actually have better results in a less aggressive option.

Behavioral research has shown that we have a bias for thinking we’re better than average. When it comes to investing, this kind of overconfidence bias is linked to lower returns with individual accounts. In a classic paper published in 2001 in the Quarterly Journal of Economics, researchers Brad Barber and Terry Odean looked at  the trading accounts from more than 35,000 households. They found that  higher levels of trading — a sign that the individual appears to think they are in the elite category and can do better than the market  — were associated with significantly lower returns.

Moreover, their research also showed that this behavior tended to divide along gender lines. Men tended to trade more than women, a sign of their overconfidence, but ultimately do worse with their turns than women overall. They discovered that men trade 67 percent more often than women do but are 1.4 percent worse off with returns before taxes. Do note that women weren’t beating the market either – they underperformed as well. Just less than men.

Marketing for financial services often tries to take advantage of this overblown sense of confidence. Hundreds, if not thousands, of books have been written about how to beat the market. It is the reason brokers will try and get you to trade and tell you things like “You’re sophisticated, and you can beat the market.”

Everyone is susceptible to this kind of ego-stroking. We want to believe that we are better than everyone else — even as brokers and financial authors line their pockets with transaction fees and book earnings.

But when you take the human ego out of the picture and just look at the data, odds are small that you’ll make more money than you would doing nothing. Nobel-prize winning research has shown that over the long term, passive investing — the kind we do here at Betterment — has better returns than active management.

So back to my lap swim: I swim in the medium lane, and noted that I kept passing those individuals in the ‘fast’ lane. The moral of this story? Don’t let marketing prevent you from doing what’s actually smartest.

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