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Overconfidence in Investments

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The body of knowledge now called behavioral finance has been developing in earnest since 1980.  The more we learn about the way we interact with money, the more we see that our instincts are often not as useful today as when humans were developing many years ago.  Our natural misconceptions are somewhat predictable and fall into identifiable categories.  One of the most common biases is overconfidence, which manifests in many when it comes to investing.

For example, we will feel most comfortable investing in things we know well, even if it means we’re undiversified.   One great example is the tendency to maintain large positions in your employer’s company stock.  Geographic home bias is a problem too, in that we’re more confident in investments in places we know.  US home bias has outperformed for the last few years, but then again Japanese investors did great investing locally up until the 1989 crash too.  Thirty years later, the price return of the Nikkei 225 average is still underwater!  When AT&T broke up into seven regional companies, investors were found not to invest in the Baby Bell with the best investment prospects but rather almost always in the one they knew locally.

To be provocative, perhaps the most costly form of overconfidence is investors who think they can select individual stocks and outperform the market consistently year after year.  Most busy people have  a hard time picking up their dry cleaning, so the idea that a working professional with family obligations can have the time to be effective at selecting individual stocks and bonds over the long run is a stretch, at best.  What’s worse is that sometimes investors think they are winning, but it’s only because they remember the winners and forget about the losers.

I remember a TV show that did a tour of famous poker player Daniel Negreanu’s house in Las Vegas.   There was a large pool table in the basement, and the host asked him if he’s any good at pool.  I remember he looked at her for a long moment and simply replied “well, I’m better than you are.”  In the same way, with over a decade of daily experience in financial markets, several rigorous financial certifications and a respected MBA, I suspect I’d be better at picking stocks than an average reader of this article.  With that said, you might be surprised to learn that I think you would be foolish to ask me (or any other investment professional) to build a portfolio for you by picking a handful of individual stocks and bonds!

What value does a firm like Telarray add over index funds then?  We don’t think we can pick stocks to beat the market, but we do believe there are ways to beat the market in the long run without outguessing the market.  Our fund providers invest broadly and algorithmically based on evidence of previous outperformance that is believed likely to persist in the future.  I believe Telarray clients have made a great choice by picking us to help assemble their portfolios from the fund providers such as these.

Aside from curating the investment portfolios, much of what we do at Telarray is behavioral.  Convincing some clients to stay the course when there is market uncertainty can be challenging, but we’ve kept many clients invested to their great benefit when they most wanted to run.  Probably the most important value we add for clients is through their relationships with their advisors, who help you understand your spending and saving in context and make the major decisions that truly affect your long term financial outcome far more than a percent of market returns here or there.     

If we were all like Star Trek’s Mr. Spock then financial planning would be easy.  We’re all human though, so we’ll continue to help you invest and make the best decisions possible amid uncertainty and human nature on the path to your secure financial future.

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