• Sunday, May 19, 2024
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BusinessDay

Beware of investors’ fatal flaw

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If you want to build wealth over the long haul, investing is a great way to go. It’s important, however, to not become overconfident — as it can quickly undo a lot of the progress you make.

Where does overconfidence come from?

A few months ago, my portfolio was doing quite well, thanks in large part to the fact that the market itself was doing well. When that happens, many of us don’t think in those terms; instead, we’re inclined to attribute good performance to our own genius.

Studies indicate that most of us feel like we are “above average” when it comes to intelligence. This means we think we’re smart enough to pick the right investments.

But as Warren Buffett has pointed out: a rising tide lifts all boats. Too many of us don’t see it that way; we attribute our good performance to an innate ability to be “above average” when it comes to stock picking.

A few successes, and all of a sudden we feel like experts. While it’s important to feel confident enough to keep investing (and to hang in there when the market drops), you need to find the balance between feeling comfortable with your investing plan and becoming overconfident in your abilities.

The danger of overconfidence

Why is overconfidence such an issue? It can lead to you taking bigger and bigger risks with your portfolio. When you think you’re a stock-picking genius, there’s a tendency to assume you can do no wrong.

When this happens, it’s tempting to deviate from your investing plan. You might feel confident enough to move away from long-term methods of building wealth and instead start picking stocks for dramatic short-term gains. While this isn’t a problem when using money you can afford to lose, it becomes dangerous when you start to change your asset allocation and experiment with money you truly need.

While you might do well for a certain period of time, at some point there will be a down day and you will lose ground. If you reach this point and panic, you could do even worse — and find yourself in deep trouble, locking in losses. At the same time, if things go downhill, you need to be able to stop your losses before they get worse.

In the end, if you’re planning to build wealth for the long haul, a solid plan based on asset allocation and indexing is often the way to go. While you might want to introduce a little more growth to your portfolio over time, you could educate yourself about other ways to invest. It’s important, however, to keep your investing in check and avoid altering your long-term plan because of overconfidence.