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This Test Proves You're Overconfident

06/02/2015 04:56 pm ET | Updated Jun 01, 2016

Much has been written about the perils of overconfidence in investing. Nobel laureate Daniel Kahneman reported one compelling study in his book, Thinking, Fast and Slow.

CFOs are overconfident

You might think CFOs of large corporations would have valuable insight about something as basic as projecting the returns of the S&P 500 index. The data, however, proves otherwise. Researchers from Duke University analyzed 11,600 forecasts by CFOs. They asked for both projected returns and the level of returns that participants were 90 percent confident were too high and too low. More than 67 percent of the actual returns were outside the estimated range. The CFOs were supremely confident, and often wrong.

Consider your assumptions

The next time you're tempted to buy or sell stock because you believe it's mispriced, think about the assumptions you are making.

First, you are assuming the price set by millions traders all over the world (traders who are looking at the same information about the stock you and broker have) are wrong. You would have to believe they missed something that makes the current price of the stock too high or too low.

Second, if you are buying, someone else is selling. They obviously believe it is a good time to sell. How confident are you that they are wrong and you are right?

Third, you don't have the benefit of knowing who is on the other side of the trade. Would you bet on the outcome of a sporting event without knowing all of the participants in the game? If you are buying, would it make a difference to you if you knew that Goldman Sachs was the seller? Is it likely you and your broker know more than Wall Street insiders?

Take this test

As noted by Andrew Macken, a senior analyst at Montgomery Investment Management, Michael Mauboussin, author of The Success Equation, has posted an online test that permits you to assess your own level of confidence. Macken indicates that more than 700 people have taken this test. Their accuracy rate in responding to the questions posed is 60.5 percent, but their confidence level is 70 percent.

According to Mauboussin, "People who think that they know more than they do are less motivated to learn and improve than those who understand their limitations. Indeed, one study showed that the least capable people have the largest gap between what they think they can do and what they actually achieve."

It's hard to resist

Even though we know predictions are notoriously unreliable, they are the daily grist of brokers and other self-styled investment "gurus." Even Macken, who is obviously aware of the data on overconfidence in making predictions, can't resist the temptation. According to a May article in Financial Review, Macken has picked Prada as the "world's leading short candidate."

I wonder how confident he is in that prediction.

2014-04-01-Hiresfrontbookcover.jpgDan Solin is a New York Times bestselling author of the Smartest series of books. His latest book is The Smartest Sales Book You'll Ever Read.

The views of the author are his alone and may not represent the views of his affiliated firms. Any data, information and content on this blog is for information purposes only and should not be construed as an offer of advisory services.