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By Christine Benz | 01-11-2012 02:00 PM

The Fine Line Between Self-Assured and Overconfident

Like fear and greed, overconfidence can often be found lurking around investors' biggest mistakes.

Christine Benz: Hi, I'm Christine Benz for Morningstar.com.

Investors often behave in ways that run counter to their own interests. Carl Richards, a financial planner, a blogger for The New York Times, and a contributor to MorningstarAdvisor.com, has written a new book that address this tendency, and it's called The Behavior Gap. He is joining me via Skype to talk about it today.

Carl, thank you for joining me.

Carl Richards: My pleasure; thanks for having me.

Benz: There has been a lot of academic research around this topic of investors who are overconfident and how that can impede their investment results. Let's talk about a sketch that you've got in the book on that front and also the experiences that you've had with investors who are overconfident.

Richards: I think overconfidence, besides fear and greed, it seems to be the little third partner of this little group that’s always lurking around big mistakes. I think it's so tricky, because overconfidence is exactly how you would expect an expert to behave. [For instance,] you don’t want an underconfident surgeon.

Benz: I don’t.

Richards: I don’t know anybody that does. You also don’t want an overconfident surgeon. So where you cross that line between confident and self-assured, and overconfidence is really, really fuzzy.

It’s a problem of experts, and so whenever you are taking care of your own money, or if you are offering advice to other people on their money, you've got to consider yourself at least somewhat confident or else you wouldn’t be making those decisions.

The key is to figure out when we cross the line from confident to overconfident. It's really challenging. As I say in the book, if you are not worried about overconfidence, it's probably because you are overconfident.

So I think we just need to be more humble about the decisions we make when it comes to investments, and realize that often our gut is wrong on the investment side. Often it would make sense to run ideas past two or three people.

The other tricky thing about overconfidence that's really a whammy is that if you have a plan that you are very confident in, and you hold on and hold on and hold on, and then you finally capitulate, you are the one that’s going to suffer the most. Because the people who bailed out early, they didn’t suffer nearly as much as you did by being confident in your plan. So there is this really fine line--confident in your plan stick with it.

Benz: So the big risk of being overconfident in your view is that you can position your portfolio to benefit from one outcome but not really position it for outcomes that you didn’t anticipate.

Richards: That's really good point. I think we are notorious for not understanding ... we are very bad in understanding things we don’t know. I think often you position ... you think you've got one outcome.

We need to pick an individual stock, or even an industry--let's say I really feel strongly that commodities are going to do well next year. The fear with overconfidence is that you position a portfolio in a way that if you are wrong, you are going to really suffer. There is a conversation I like to have called the overconfidence conversation where you just ... give yourself permission to consider what would the impact be if I am right, and what conversely, and be careful, what would the impact be if I am wrong about this decision? How would my life change?

Benz: So the idea is that you don’t want to position your portfolio to benefit from all-or-nothing outcomes. You really want to think about what's the devil's advocate case for this thing that I think I am so sure about.

Richards: There can be reasons we'd want to roll the dice on an all-or-nothing outcome. But you certainly wouldn’t want to do that without at least recognizing that’s what you are doing.

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