Broker Check

Managing Behavior Through (Behavioral) Finance: Part I - Overconfidence

| June 08, 2018

In our daily lives as planners, we meet with a variety of people from all walks of life, and we see many of the same financial mistakes made over and over again. This is not meant to assign blame to our clients (it would be a bad business model if we did!). To the contrary, many of the pitfalls that our clients succumb to may be less nurture and more ;nature – specific behavioral biases that are so ingrained in human decision-making processes that they are performed subconsciously.

This is specifically what behavioral finance studies – this area of psychology focuses on the subconscious biases that affect financial behavior with the end goal of counteracting such biases in order to make better financial decisions. In This series of articles, we will focus on a few key areas of behavioral finance as it relates to financial planning with the end goal of a) identifying the key biases as they relate to financial planning and b) discussing different ways of counteracting such biases so you can make better financial decisions. In Part I, we will focus on the easiest to understand of such biases – overconfidence.

Overconfidence Bias and Where We’ve Seen It

Psychology has found that humans tend to have unwarranted confidence in their decision making – that is, we have an inflated view of our own abilities. This overconfidence bias has been studied throughout society, in everything from driving (where a study found that 93% of US drivers stated they were more skillful than the average driver[1]) to love (a French study found that 84% of Frenchmen believed they were above average lovers[2]) to teaching (a study found that 94% of college teachers believe themselves to be above average[3]). Just let the above math sink in.

This can also be seen in behavioral finance as well. Results of a 1998 Cal Berkeley study found that investors are more likely to sell their winning stocks than they are to sell their losers – they tend to sell their winners 50% more of the time than their losers.[4] There are many reasons for why this may be the case – tax law changes, transaction costs, capital gains, etc. One of the main reasons put forth, however, is the investors’ overconfidence – they firmly believe that they cannot possibly be wrong about a buying decision, and they make excuses for why the stock has not taken off yet – the words “wait” and “until” show up in the same sentence (this same scenario has to do with another bias which we will get to in a moment).

We have seen the overconfidence bias time and time again as it relates to one’s company stock. Many times, we have seen individuals who have received corporate stock options or restricted stock, and have desired to keep significantly more than we have advised. We advisors do understand this conundrum – this is the company they sweat and bleed for, and the one company that they feel they truly understand (or even have some “insider” knowledge of). However, the overconfidence bias, at its core, is linked to the issue of control – such clients believe they exercise more control over their company stock than they actually do, and they are actually worse off by being so intimately connected to the company. They will continue to be unduly optimistic about the performance of their corporate shares and underestimate the impact of outside forces (the economy at home/abroad, governmental impact, etc.) that may adversely affect the company’s shares.

The overconfidence bias does not only impact investments; we also see this bias as it relates to some of life’s big risks - particularly disability and long term care. A 2014 Council for Disability Awareness Survey found that 57% of respondents had never discussed how to deal with the financial consequences of an extended disability.[5] When asked why, respondents provided two most oft cited reasons: 1) they underestimated the likelihood of becoming disabled (and if it did occur how long it would last) and b) an overconfidence regarding the resources that would be available if a disability did occur.[6] In another study, 64% of American respondents believe they have a 2% or less chance of being disabled for three months or more during their career.[7]

Americans also have a degree of overconfidence regarding long term care. In a 2008 Lincoln Retirement Institute Survey of US baby boomers, 59% of respondent boomers believed that others should prepare for long term care costs by purchasing long term care insurance, yet only 35% of those individuals are utilizing such insurance for their own planning.[8] In this same survey, more than 40 percent of those surveyed estimate the average 65 year-old has a 60 percent chance of needing long-term care for three months or more at some point in time, but only 30 percent said they run the same risk in the future.[9]

We have seen this overconfidence as it relates to insurance in our own practice. We are constantly discussing disability and long term care with our clients, and most of the time our clients do get the risks that these long term illnesses may pose. However, every once in a while, we will catch a whiff of skepticism regarding the probability of disability/needing care and the accompanying cost. We have seen this overconfidence bias dwindle once such individuals are touched by someone in their lives who have had a disability/needed care. When they are managing their parents’ affairs after one or both of them go into a home and they are stroking $8-$12,000 checks each month, watching their parents’ assets dwindle, you can see that this type of risk can affect anyone, including your own family.

Last but (probably) most importantly, it is important to note that the overconfidence bias can potentially affect retirement as well. The first piece of overconfidence as it relates to retirement is longevity. Americans simply do not understand the risk of outliving their money, and assume that the average lifespans are significantly shorter nowadays than they actually are. For instance, in a 2012 study by the Society of Actuaries, of the retirees and pre-retirees who guessed the age to which an average person of his or her age and sex could expect to live, about 4 in 10 underestimated the age by five or more years and another 2 in 10 underestimated it by 2 to 4 years. More significantly, only 4 in 10 retirees correctly responded that about half of 65-year-old men and women can expect to live until median life expectancy—indicating that the variability of life expectancy is not well understood.[10] Worse yet, about one-third of retirees and pre-retirees say they look less than 10 years in the future when they think about retirement finances, and another one-third look 10-19 years in the future.[11]

It could very well be that people do not understand the magnitude of how much longer people are living people today, but it may also be hubris (interesting enough, in another study, people tend to believe that they will live longer than others their age). We have seen a small sliver of clients who have certain beliefs about our retirement modeling. First there is the longevity issue noted above, which clearly is a debunked idea.

Second, they seem to believe that they will not need nearly as much in investable assets as our modeling tells us – they believe that they will not spend nearly as much in retirement, thus we are overestimating how much in investable assets they need to accumulate. Based on our experience, this is really dependent upon the person. For those that are frugal already, they do tend to button up even further in retirement. However, for these individuals, most of the time they have done a good job of saving already (unless their earnings are limited), and they actually could go the opposite way and spend more in retirement. However, if you are a spender who has shown a proclivity of having an overconfidence bias, it is our experience that you will actually spend more in retirement than during your working years, particularly the critical first 10 years. We believe this may be due primarily to monotony, but whatever the reason, they may actually end up needing more than what our modeling tells us! For many of these clients, we end up seeing them once and we never see them again, and we think they may not want someone calling them out on their overconfidence. It is a shame, since these individuals are the ones that really do need the most help.

Overconfidence Avoidance Tricks

  • Continuously Learn

The psychologists David Dunning and Justin Kruger summed up their infamous psychological idea (the Dunning-Kruger) effect many years earlier by saying “the trouble with the world is that the stupid are cocksure and the intelligent are full of doubt." What is the point of this statement? Always be learning as a way to avoid overconfidence. If you do not have an advisor, consider one as a way to learn. If you have an advisor, ask as many questions as you can, but do listen to them, as their job is to protect you from this overconfidence. Learning is a way to combat the ills of overconfidence.

  • Reflection

If you want to overcome the pernicious effects of overconfidence, you should think yourself into the following scenario: Imagine you are one year down the line from making a financial decision and it has gone spectacularly and horribly wrong. The overconfident may imagine that any future similar decisions will go differently and fabricate some rationale as to why this past decision failed, but of course it won’t happen again if a similar course is taken. Do not let this happen. Reflect as to why this past financial decision failed, and how the future decision can be tweaked or completely avoided in order to avoid this overconfidence.

For example, we met with a couple in their early 50s who was in significant debt with very little accumulated for retirement, and in the past had taken out loans in their name to pay for their daughter’s college. They wanted to do the same for their son when he went to college, since it was the “fair” thing to do, even though it would deepen their risk for retirement. We would note, we do not blame them for their train of thought – the moral path was completely understandable, but the destruction it could cause by the financial path was far outweighed. Thus, a decision point was made – they could make a similar poor financial decision without considering the past, or they could consider the further hole this past financial decision has put them in, and utilize these funds for their retirement. It is true, their son would need to take out loans, and some resentment could result in the family, but we doubt either child would want to see their parents living on food stamps.

  • Objectivity

This last piece of advice is fairly straightforward, but having someone in your life that can offer some objective advice regarding your financial decisions is really important. You need a sounding board from someone not tied to the financial decision, and the further the person is tied to you, the better. That could mean a financial advisor/planner (us!), but at the very least it could be a close family friend/parent/sibling (they may still be somewhat tied to you, but they will offer at least partial objectivity).

Of course, we are here to help. If you want to discuss any of the points in this article, please feel free to reach out to either of us!

Karen DeRose and Anthony DeRose are registered representatives of Lincoln Financial Advisors Corp.

Securities offered through Lincoln Financial Advisors Corp a broker/dealer (Member SIPC) and a registered investment advisor. DeRose Financial Planning Group is not an affiliate of Lincoln Financial Advisors Corp. Lincoln Financial Advisors does not provide legal or tax advice.