jar-of-pennies

The issue: Overconfidence

People tend to attribute successes to their own actions, and blame failures on external factors. Further, clients who experience success in investments, particularly early on, often become overconfident in their abilities to make the right financial decisions.

Warning signs

That overconfidence can breed a tendency to diversify less and trade more aggressively, which creates challenges if you’re their advisor. Likewise, clients who are successful in their own careers often misinterpret their influence over other areas of skill beyond those confines. It’s a mental process psychologists call transference. A successful doctor may believe she’s also a proficient investor. A boxer could transfer his sporting prowess and confidence to his portfolio by taking greater risks.

Clients who believe they can control activities where they actually have little or no expertise often start trading too much. This is bad, because statistical analysis of discount brokerage accounts shows such frequent trading erodes performance.

Protect clients

To help clients overcome overconfidence, show them data that clearly demonstrate the patient investor often comes out ahead.

For example, contrast the net-of-fees performance of clients who patiently sat through recent business cycles to those of clients who didn’t; more often than not, the patient ones fare better (see“Earn more, trade less”).

Second, bring in the human element. Recent work in the field of neuroeconomics shows people’s decisions change based on external influences. For example, showing a man pictures of his wife and children may reduce the likelihood that he’ll take risks with the family finances.

Or, show your client a picture of his aged face and say, “Here’s the person you’re saving for.” Chances are he’ll be more patient and cautious because he cares about the person in the image.

Finally, honesty can be the best tool for curbing unfounded overconfidence. Advertise the way you’re compensated and make it known that some of your recommendations will reduce your own paycheque.

For example, tell your client, “If I did this trade for you, I would benefit by this much. However, my advice is not to do it.” That’s jarring, and helps to enhance the credibility of the advice you’re providing.

Age Matters

With age comes experience. A 30-year-old with five years of investment success is more likely to demonstrate overconfidence than a 50-year old in the same situation. With more time, people have more data to analyze, and recent success has less weight in decision-making. The 50-year-old can say, “Maybe I’ve gotten better in the last five years, but I remember the 15 years when I didn’t do as well.”

Originally published in Advisor's Edge