Avoiding overconfidence when investing

Even though the market averages through last Friday were little changed for this year, we have had a very strong stock market in recent years. Given that most investors have likely made significant money over this time period, many individuals are probably feeling rather confident.

When evaluating how well someone is doing when investing, it is important to differentiate between relative and absolute performance. Absolute performance is just your actual return for a specific time period. Relative performance compares your return relative to a specific benchmark.

Generally speaking most individual investors are more focused on absolute performance.  This is not surprising given that people are primarily concerned whether they are making or losing money, when it comes to investing.

However, the proper way to evaluate one’s investment success is to look at relative performance. This is applicable whether you are managing your own investments, or have an investment advisor. For example, if the stock market is up 20 percent in one year, and your return is 15 percent, you have underperformed.

Likewise in another year where the stock market is down 10 percent, and you lost 5 percent, that would be outperformance. Obviously someone will feel better getting a 15 percent return versus losing 5 percent, but the person who lost 5 percent, when the market declined 10 percent showed greater investment skill.

During strong markets investors tend to be less focused on the fees they might be paying for mutual funds, or to an investment advisor. For example if the market is up 20 percent, an investor might return 19.9 percent investing in an index fund.  Another fund having the same gross return, might net only 18.5 percent after fees.

Many investors might think their fund had a very good year returning 18.5 percent, when in actuality they could have done better. When stock market returns are lower, or even negative, fees tend to be more noticeable versus when times are good.

For people who pick their own stocks, there is a tendency for returns to be significantly better, or worse than the market averages. This is because most individuals will have less stocks in a portfolio versus one professionally managed.  In addition many individual investors will not be well diversified across industry groups.

This investment strategy may work very well in strong markets, and give someone a false sense of their investment prowess. For example the last several years the over the counter market has done considerably better versus the broad based S&P 500. Investing primarily in just over the counter stocks is a riskier strategy, so someone may have achieved higher returns just because he/she took on more risk.
Oftentimes people who are successful in their careers or businesses have a very strong sense of confidence in their abilities. This sense of confidence often extends to the investment arena, and is obviously reinforced when we are in an environment of stocks doing well. However, this confidence can be easily shattered once stocks have one of their periodic corrections.

There are those who feel they can just exit the stock market, when stocks are doing poorly. However, studies have shown that the most successful investors do not try to time the market in any major way. Obviously some adjustments can be made depending upon market circumstances, but a strategy of either 100 percent or 0 percent stocks seldom works.

It is important for investors to know not only their actual return, but how one’s investments are doing versus a standard benchmark. Also, in a retirement account at work, or even a personal account where money is being added, returns need to be calculated net of new contributions.

We have had a good market in both stocks and real estate, over the past several years.  However, even though some of us may be wealthier, that doesn’t necessarily imply we have become smarter, or more skilled in our investment abilities.