Your Money & Your Brain - Confidence

What I love about this book is that its findings and applications apply to many areas in life. At a later date, I will post a blog on how these same principles apply to social policy and human motivation.

In Chapter five, Zweig discusses the dangers of inherit in confidence. We as humans have a tendency to believe that we are better looking, smarter, funnier etc. than we really are. Studies show that we rate ourselves consistently above average on any item measured. How can that be? by definition we all cant be above average. This is not a bad thing, if we didn't have confidence we we would never take risks.

Unfortunately, in investing, this overconfidence can lead to underperformance:

* We believe we are smarter than the collective market. Surveyed investors believe they will outperform the market by 1.5 percentage points. Mutual fund investors believe the funds they pick will outperform the market. Again, how can we all beat the market?

* We put too much faith in what is familiar. This "home bias" leads to too little allocated to foreign investments and too much invested in our own companies stock (think Enron). Brain scans of investors show that when considering placing money in foreign markets their amygdala (brains fear center) kicks in. Staying close to home feels safer.

* We think we have more control than we do.

* We have "hindsight' bias. We think we predicted what occurred, which leads us to think we can predict the future.

* We hate to admit that we don't know something. Ironically, this means we are overconfident in our abilities to overcome our overconfidence.

A great point in the chapter is Zweigs discussion of "illusion of control". More than any other activity except sports and gambling this effect exists in investing. Illusion of control exists when:

* activity appears partly random

* there are choices

* involves competition

* can be practiced

* requires effort

* feels familiar

This results in what Zweig calls the Colonel Klink illusion. You think you are in control. But you are not.

What can we do to protect ourselves:

1. You need to say "i dont know" then learn more.

2. Discount your expectations by 25% before you act.

3. Write down why you made the decision you did. Write out "i think this investment will go up because_______________."

4. Learn what works by tracking what doesn't

5. Don' t just buy what you know and don't get stuck on your co.'s stock.

6. Diversification is the best defense.

This last point is huge. I have studied investing for the last 25 years, I am convinced that there is no better investing strategy other than building a well diversified portfolio that is appropriate for your capacity for risk and doing little, other than re-balancing it annually, or adjusting for changes in life circumstance.