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.
Due to the difficulty of establishing the true value of an asset, investors may fixate on reference points, such as a fund’s past outperformance, to help them make investment decisions. Making comparisons and estimates based on these values is known as anchoring.
However, such reference points are often arbitrary and irrelevant, so subsequent decisions can be negatively affected, resulting in an investor holding onto losing stocks for too long or selling winning stocks too early—known as the disposition effect. An overconfident investor who is prone to holding onto a particular belief often has difficulty adjusting their views to new information.
Herding behaviour is when investors base their decisions on the actions of others. With the pandemic causing more of us to fill more of our time with social and traditional media, herd mentality may be increased. Growing interest in certain stocks or trends, and the news around them, is a sign of this.
Some investors engage in spurious herding, where they make similar decisions to others because of the similarity in the information available to them and their views towards this information. Others engage in intentional herding, where they deliberately imitate the behaviour of others, who they assume have insight into the situation.
If the original information available to other investors is inaccurate, it can prompt bad decisions that will eventually result in losses. Overconfident investors are quick to act on incomplete information, so are susceptible to both forms of herding.
An adviser’s role in navigating confidence
With an overconfident and excitable investor, there’s always the risk that they decide they don’t need the services of a financial adviser at all. But financial confidence is no substitute for sound advice.
A financial planner with an in-depth understanding of the unique circumstances of each client not only helps to generate and protect wealth, but also supports wellbeing.
By working closely with the client and communicating regularly, an adviser is able to provide tailored advice, create a diversified portfolio and ensure that the client makes decisions that will help them to stay invested for the long term. The key elements of this are:
1. Helping an investor understand their risk tolerance
For some confident investors with a high self-perception of their risk tolerance, there is a tendency to panic and sell investments when faced with real investment loss. So how can we help these investors?
