Dollars and Delusions: How Overconfidence Can Cost You Millions

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"One of the painful things about our time is that those who feel certainty are stupid, and those with any imagination and understanding are filled with doubt and indecision."

 - Bertrand Russell

Most people think they are a lot smarter than they really are.

Academics feel that degrees from top schools make members of “the anointed.”

Former underachieving students who have found financial success often take comfort in their wealth and praise their "street smarts" over traditional academic intelligence

Well, book-smart academics have studied this phenomenon.

They have discovered one of the most important mental models ever—and one that applies to the investing world.

The Dunning-Kruger Effect

Cornell psychologists David Dunning and Justin Kruger conducted a series of psychological experiments on Cornell students in 1999.

They unearthed a compelling cognitive bias.

Incompetents end up making poor decisions and reach erroneous conclusions.

They tend to overestimate their skill level, fail to recognize genuine skill in others, and suffer from illusory superiority, rating their ability much higher than it actually is.

They don’t know what they don’t know.

One study found that 32-42% of software engineers rated their skills in the top 5% of their companies.

Another concluded that one out of five Americans believe it's 'very likely' or 'fairly likely' that they'll become millionaires within the next 10 years.

And, of course, all drivers famously rate themselves above average.

Much like in Garrison Keller’s Lake Woebegone, everybody is above average.

Investing and the Dunning-Kruger Effect

“Ignorance more frequently begets confidence than does knowledge.”

-Charles Darwin

The Dunning-Kruger effect is alive and well in the world of investing.

According to one study, 93% of US investors fancy themselves as above average.

Another study by English bank Schroders Global in 2016 found that only 13% of investors globally admit to being below-average investors.  

The reality is far less flattering,

Fidelity Investments conducted a study on their Magellan fund from 1977-1990, during Peter Lynch’s tenure. 

Lynch’s average annual return during this period was 29%.

You would expect that Magellan investors made a fortune.  

Not so.

I have seen three estimates of Peter Lynch’s record. All reach the same conclusion.

One states that the average investor lost money.

Another study suggested that the average Magellan investor earned just 2% per year. 

Lynch himself calculated that the average investor in Magellan made only around 7% during his tenure.

Source: business-standard.com

What explains the shortfall?

Panic selling and exuberant buying at the wrong times

When Magellan suffered a pullback, investors would redeem shares in the fund.

Once the fund recovered, money flowed back in.

What a Real Expert Looks Like

Those who genuinely know their stuff are considerably modest compared to those with a fraction of their experience and knowledge.

The cruel irony is that competence makes you less confident.

As Dunning and Kruger conclude, "the miscalibration of the incompetent stems from an error about the self, whereas the miscalibration of the highly competent stems from an error about others."

The incompetent overestimate their abilities. That’s an error of the self.

The competent underrate their own abilities, and suffer from illusory inferiority. That’s an error about others.

The incompetent live by the philosophy:

“Fake it until you make it.”

The competent suffer from the knowledge that:

“The more you know, the more you realize how little you know.”

Investment Overconfidence: A $2 Million Mistake

A study by Dalbar, a leading financial services market research firm, showed that the S&P 500's return over the 30-year period ending December 2013 was 11.11%. How did individual investors do over the same period? They returned just 3.69%

How did individual investors do over the same period? They returned just 3.69%

This is an astonishing 7.42% difference annually.

If you had invested $100,000 in 1984 in the S&P 500 and earned 11.11% today (30 years later), you would have $2,358,275.

If you had started with $100,000 and invested it over the same period at 3.69%, you would have $296,556.

That is a difference of $2,061,719.

Dalbar found that investors' belief in their own investment ability has cost them around $300 billion in investment returns over the last twenty years.

What is To Be Done?

The harsh truth is this:

Individual investors are lousy at investing.

But the siren call of the market is irresistible to many.

My recommendation?

Set aside 10% of your investment portfolio to “play the market.”

Put the remaining 90% into an index fund.

Accepting that you are not as smart as you think may be the best investment you will ever make.