3 Ways To Prevent Overconfidence From Derailing Your Retirement Plans

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By Walter Updegrave, RealDealRetirement @RealDealRetire

Confidence can be a powerful force. RAND Corporation researchers have found that people who felt confident were more likely to plan for retirement than those who were more tentative. But confidence can cut both ways.

The rub is that confidence can too easily slip over the line to overconfidence. For example, EBRI’s 2014 Retirement Confidence Survey notes that Americans’ confidence in their ability to afford a comfortable retirement has been recovering from the lows of the financial crisis. Which is good, except the report then goes on to say that this rebound in confidence isn’t backed up by better planning for retirement:  “Worker savings remain low, and only a minority appear to be taking basic steps to prepare for retirement.”

Psychologists and economists have long been fascinated by The Overconfidence Effect: the tendency for people to overestimate their judgment and abilities. Frenchmen think they’re better lovers than they are; university professors ovrrate themselves as teachers; investment analysts have an exaggerated view of their ability to forecast stock prices. Berkeley finance professor Terrance Odean has published numerous papers showing that overconfident individual investors sabotage their investment performance by trading too much.

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So, how can you reap the advantages confidence can bestow without falling prey to overconfidence? Here are three tips:

1. Challenge yourself. The next time you’re about to make an investing or retirement-planning move—say, diversify into a new asset class or convert a big portion of a traditional IRA to a Roth IRA—ask yourself for a detailed rationale of why you believe this move is necessary, what evidence supports that view and what, exactly, you expect this move to achieve for you. Then come up with reasons this strategy might fall short of expectations and assess what the downside might be. And do it in writing, as this will force you to be more rigorous in your arguments. You might also go to one of the calculators in RDR’s Retirement Toolbox and plug in new investments or other strategies to see whether they enhance your retirement prospects.

If you go through this exercise and come away still convinced you’re doing the right thing, fine. Proceed with your plan. But if you raise issues that highlight potential weaknesses you hadn’t really thought through, you may want to hold off until you do more research, or just scale back your original plan (invest less than you’d originally intended in that ETF or convert a smaller amount to a Roth).

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2. Keep a record. I don’t know about you, but I tend to remember clearly the times I was right about something and forget or gloss over the times I was wrong. That’s only natural. But to protect against this instinct—and give yourself valuable perspective on how often future events prove that your analysis (or gut instinct) was right or wrong—jot down your various predictions and date them. Believe that small-cap stocks are about to surge or inflation is poised to spike or the value of the dollar will fall? Write it down. That way you’ll be able to check back and see how good a financial seer you really are.

Here’s an exercise you can do right now. Think back to when the market was still on a roll before hitting the wall in 2008. Were you predicting stock prices were about to plummet? Did you act on that prediction? How about back in 2010 when everyone was absolutely convinced the bond market was in a bubble and prices were about to burst? Were you part of the bubble crowd? Bond prices did eventually drop and hand investors an annual loss. But that didn’t happen until three years later in 2013, and the loss was hardly devastating: about 2%. Meanwhile, people who fled bonds to hunker down in cash lost out on a gain of nearly 20% from 2010 through 2012, a three-year span during which money market funds and the like returned a total of less than 0.5%.

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3. Put yourself on a short leash. It would be nice to think we act only after rationally thinking things through. But humans always have and always will also act impulsively and irrationally. So rather than trying (probably unsuccessfully) to completely stifle that impulse, you may be better off indulging it, but within strict limits. One way to do that: set aside a small amount of money in an “experimental” reserve account that you can invest or use however you please. The only stipulation is that this money remain separate from your regular savings and investments so you can easily see how well, or badly, your reasoned analyses, hunches, gut instincts, fliers (whatever you want to call them) turned out.

Who knows, if this account grows in value over the years, you may want to incorporate some of your “experiments” into your investing strategy. But if this account lags the growth of your regular portfolio or seems to be slowly seeping away, it may provide just the incentive you need to leaven your confidence with a little humility before you make your next financial decision.  (9/28/14)

Walter Updegrave is the editor of RealDealRetirement.comIf you have a question on retirement or investing that you would like Walter to answer online, send it to him at walter@realdealretirement.com.

 

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