As we begin to emerge from the pandemic, many of us are turning attention to our plans for when life becomes more normal.
The past 18 months has provided plenty of reasons to feel risk averse. But it has also been a time to reflect on and reassess our life goals, and a period in which many have built up savings. This brings with it a sense of achievement, which in turn can increase confidence in our ability to adequately control our finances.
A confident investor who is willing to take risk is a good thing, but there are a number of behavioural and cognitive biases to watch out for. By understanding a client’s personality traits and tolerance towards risk, an adviser has a crucial role to play in striking the balance between a confident and overconfident client.
Financial confidence is key, but overconfidence poses dangers
For an investor, having confidence and self-efficacy—belief in their abilities to manage their finances to achieve their financial goals—is key. In fact, these are precisely the characteristics that an adviser will seek to promote in their clients.
By developing stability and resilience, an investor is more able to bounce back from difficult periods, adapt in the face of adversity and, ultimately, stay invested for the long term.
Given that one of the difficulties many people experience with their money over the long term is being willing to take enough financial risk to reach their goals, a client who wants to take on risk can be welcome. However, calibrating this risk is key.
Being self-assured is one thing, but displaying signs of overconfidence poses dangers. Investors who are overconfident and overoptimistic may overestimate their own level of knowledge and the accuracy of their decisions.
Consequently, they may underestimate perceived levels of risk and end up taking greater risks unnecessarily. An investor who is outgoing and bold, and/or curious and open-minded, may be particularly susceptible to becoming overconfident.
Confirmation bias is a danger
Overconfidence can be fuelled by confirmation bias, where an investor places too much weight on one particular source of information that reflects their own opinions and therefore increases their confidence.
Too much confidence can also lead to attempting to time the market due to a perceived level of skill and an illusion of control. If this goes well at first, it can, in turn, lead to self-attribution bias, when an individual readily credits positive outcomes to their own skills, as opposed to luck, research or the economic climate.
The repercussions of overconfidence can be damaging, and potentially lead to financial losses, so helping an excitable client to control their risk-taking is key.
Watch for biases in excitable investors
When a client becomes overconfident, they tend to disregard the experience of their adviser and even the evidence provided by research, being influenced instead by their biases. Research shows that two of the most common characteristics of overconfident investors are anchoring and herding.