If you’ve ever played poker, you may have heard this: The worst mistake you can make when playing poker is to assume you are the smartest person in the room.
Pokers experts say that overconfident players often predict they have the best hand—or that they are the most talented bluffer—in the game. As a result, they make overly large, risky bets. They ignore warning signs that other players might have better cards. In short, overconfident poker players set themselves up to lose. And because they’ve often overextended themselves and aren’t strategic, they tend to lose big. That’s why avoiding overconfidence is critical to investing.
I’ve found that in the investing world, the worst mistake you can make is the same as that in poker: Assuming you’re smarter than everyone else and can predict financial outcomes.
The recent presidential election is a good example. First, did you correctly predict the winner in that hotly contested race? Even if you did, you might have predicted that the U.S. economic market would take a massive fall if Trump won. And you would have been wrong. (The market fluctuated wildly the night of the election, but eventually stabilized.)
Brashness Leads to Mistakes
A big reason that overconfidence is problematic: it may be based on a lack of knowledge. One Cornell University study showed that students wrongly predicted they would get their highest scores in the academic areas (test questions) in which they actually had the least information and experience.
A prominent study by the University of California at Berkeley’s Terrance Odean*, shows that overconfident investors also tend to make more mistakes and earn lower returns than average investors. Why? Overoptimistic investors lack knowledge. They tend to trade too frequently and incorrectly time the market. Constant trading can lead to more mistakes, greater losses and higher transaction fees. In other words, overconfident investors end up doing more things wrong at all the wrong times.
Overconfident Investing: No One Has a Crystal Ball
Since the election, a good number of clients have asked me to predict the U.S. financial future and tell them what to do with their investments. Should they liquidate their holdings and move entirely to cash? Stop investing overseas? Change their tax strategies?
My answer is simple: I don’t know. In fact, no one knows. Anyone who says they can predict what will happen in the financial markets—including experienced Wealth Advisors—is mistaken. When you try to predict, you get into trouble.
Clarifying What We Do and Don’t Know
My mantra is this: Being an investor is about having the humility to know what is actually knowable, and to make peace with the factors you can’t know. (Sounds kind of zen-like but it’s true!)
Two things we can predict in the financial world, and we don’t have a lock on the timing of these things. Here’s what’s knowable:
- Which investments are good values (bargains) compared to others;
- The combination of stocks that could best help you diversify your portfolio because they usually move independently of each other. When one equity class moves up, the other investment(s) move in a different direction and provide diversity.
Four Things we can’t know, and need to make peace with, include:
- What direction the overall U.S. financial market is heading;
- What financial changes may occur as a result of a new president;
- Exactly what tax changes are coming down the pike;
- The impact of a new president on foreign investments.
Three Safe Bets For the Year Ahead
So what do we think an investor should do right now?
- Look for new investment opportunities that may arise as the political environment shifts.
- Pay attention to new tax rules and laws that may create financial planning opportunities.
- Maintain your well-diversified portfolio. Don’t try to predict economic changes or time the market.
In other words, stay the course. Don’t be financially impulsive. Avoid all-or-nothing investment strategies.
Remember: It’s those overly confident players who usually lose all their chips. No single person ever is the smartest poker player—or investor—in the room. However, working with a knowledgeable, levelheaded financial team means the odds will should be in your favor.
*Journal of Finance, “Are Investors Reluctant to Realize Their Losses,” Terrance Odean, October 1998
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