Avoid Self-deception While Investing

Americans have the tendency to overestimatetheir skill level in many arenas. For example,most of us think we are better automobiledrivers than we really are. When groups are askedhow many members are above average in their drivingskills, approximately 80% respond positively.Since only 50% can be above average, 30% mistakenlybelieve they can handle a car better than theyactually can. This idealistic, positive report extendsto specialty groups and professionals as well. Wheneducators describe their teaching ability, 94% saythat they are better at their work than fellow teachers.Again, only 50% can be better.

Investors—professionals and nonprofessionals—show similar results. A group of architects was askedto estimate the return in their pension plans the previousyear. They recalled their investment performanceas 6% higher than the actual return. They also estimatedthat they beat the market by 5% more thanthey actually did. Similar studies performed withfinancially educated investors showed similar results.

Many of us can't face up to the reality that ourfinancial decisions don't turn out as we expect.Sorting through the expensive aftermath causes toomuch pain for close inspection, and few people haveenough courage. Therefore, we attempt to minimizethe negative impacts and accentuate the positive evidence.We are willing to deceive ourselves—some ofus more than others.

Brain Fiction

William Hirstein, in his book (MITPress; 2004), discusses self-deception, such as the typethat investors make regarding their financial outcomes.In the box on the left is an interview withHirstein, which reveals the concepts in his book andhow they are applied to the marketplace.

Advice for Investors from William Hirstein

WH: It's important to know that you don't know[everything]. I would think it would be disastrous if youthought you knew and you didn't know. So, it might bewise to underestimate the amount of your knowledge andto keep seeking more, rather than fall into the trap of feelingyou know everything to put your money here.

SMM: There are two sources of information—emotionaland intellectual—does self-deception apply to both?

WH: I would think it would be important to keep trackof your own emotions and think about where they led youawry. For example, you can convince yourself that yourteam has a chance to beat another team that is actuallybetter, but it's wishful thinking.

SMM: I'm thinking that some of our financialsources may be plagued by self-deception.

WH: Give everybody a credibility rating and adjust itup and down.

SMM: What thought processes lead people astray?

WH: Watch out for the following scenario: We have atendency to overrate ideas because we came up withthem. There is a tendency to think that I am such a cleverfellow, because I alone have noted this. You have to reinyourself in.

Shirley M. Mueller, MD, dissects barriers to effective monetarydecisions so they become manageable. Her unique training andexperience as a practicing physician board certified in neurologyand psychiatry, combined with her 7-year investment advisorcareer, contribute to her expertise. She welcomes questions andcomments at MyMoneyMD@aol.com.