Confidence when you’re handling your finances is a good thing. It can help you feel in control of your financial future, but it is possible to be overconfident too.
Indeed, overconfidence is a type of cognitive bias that could affect investors and may be associated with harming your investment returns. Investors who overestimate their skill or knowledge could be more likely to make poor financial decisions, here are four reasons why.
1. You may take more risk than is appropriate
All investments carry some risk, but being aware of what level of risk is appropriate for you is essential.
If you’re feeling overconfident, you might be more likely to choose options that are riskier in the hope of generating higher returns. Over time, it could lead to your investment portfolio being more exposed to volatility and place it at a greater risk of falling in value. This is particularly risky if your investment time frame is within the next few years.
To overcome this, always refer back to your risk profile when making investment decisions.
Your risk profile should consider your long-term goals, capacity for loss, wider financial circumstances, and more to help you balance risk and potential returns.
2. You might be tempted to try and time the market
A common trap for overconfident investors is thinking they can “time the market” – where they’d buy low and sell high.
While this sounds like a good theory, in practice, timing the market consistently is impossible. So many factors and unexpected events affect short-term movements, that make predicting how the market will react incredibly difficult. In fact, even investment professionals, who have a wealth of resources at their disposal, get it wrong at times.
Rather than outmanoeuvring other investors, someone who tries to time the market is more likely to miss out on long-term returns.
Instead of trying to build returns quickly, focus on your long-term goals.
3. You’re more likely to overlook research
Feeling confident in your choices is great, but not if you assume you already know everything there is to know about an investment. That’s a mindset that could lead to you skipping the necessary due diligence and potentially overlooking something significant.
For instance, you might have identified a company you believe will be the next big thing – the stock that everyone wishes they had invested in at the early stages. So, rather than looking at the company’s performance or checking how the investment aligns with your goals, overconfidence carries you, and you invest without seeking additional information.
Relying on hearsay or a simple feeling could lead to investment decisions that aren’t right for you. Instead, taking a slower approach, where you carefully assess the options, could lead to an investment strategy that’s based on research and reflects a wider financial plan.
4. It could lead to an unbalanced portfolio
Overconfidence may cause an investor to favour a particular type of investment, such as a certain sector or international market.
A lack of diversification in your investment portfolio could mean it’s more vulnerable to volatility.
For example, you might spot a high-risk technology niche, but you believe it’ll perform well and has the potential to deliver high returns. So, you move more of your wealth into this area. If your hunch is incorrect, your portfolio could experience a sharper decline than it would if it was balanced.
Instead of focusing on one area, spreading your money across multiple sectors and markets could make your investment performance more stable. This is because downturns in one area might be offset by gains in another.
Working with a financial planner could reduce the effect of cognitive bias
Overconfidence is just one example of cognitive bias that might affect your decisions as an investor.
One way to overcome bias is to work with someone who can offer you an outside perspective and highlight when decisions could harm your finances. If you’d like to discuss how we could work together, please get in touch.
Please note: This blog is for general information only and does not constitute financial advice, which should be based on your individual circumstances. The information is aimed at retail clients only.
The value of your investments (and any income from them) can go down as well as up and you may not get back the full amount you invested. Past performance is not a reliable indicator of future performance.
Investments should be considered over the longer term and should fit in with your overall attitude to risk and financial circumstances.