Overconfidence is the natural enemy of the self-directed investor. It tends to lead to higher risks and lower returns. For advisers, overconfident investors present both a challenge and an opportunity.
From a behavioural finance perspective, overconfidence means we tend to under-estimate the level of uncertainty in our decision-making. Overconfidence becomes particularly dangerous when paired with another common bias: over-optimism – the tendency to see the world through rose-coloured glasses. Research shows that the world appears particularly rosy when we direct our gaze at ourselves. These are inherent human biases, however, as with everything, they affect some people more than others.
What does it mean for advisers?
The good news is that these biases, and the risks and potential poor investment performance they contribute to, create opportunities for advisers to create substantial value for self-directed clients. The bad news is that overconfident people, by the nature of the bias, are less likely to seek and accept advice. Why use an adviser when they can already manage their investments just fine themselves?
There are three ways advisers can tailor their approach to attract and help more overconfident investors.
1. Create awareness
The first step is to help investors become aware of the issues and the implications. Overconfidence among investors can leave them more exposed to the risk of poor investment returns, ultimately leading to a reduced chance of meeting their retirement objectives. This can work through a combination of mechanisms that make overconfident investors more likely to overpay for growth opportunities, incur higher trading costs and taxes, and create higher volatility portfolios.
2. Tailor engagement
The preferred approach for an overconfident investor is likely to be quite different from that of a traditional ‘mum and dad’ client. Rather than seeking assurances, the overconfident investor may require their confident veneer to be disturbed and challenged.
One way to achieve this is through a number of simple tests for overconfidence. These can help to identify the issue while offering the client an interesting and engaging experience. It can also minimise the risk of the client taking personal offence to an adviser’s suggestion that they may be overconfident.
3. Tailor value proposition
Hidden psychological biases are often difficult for clients to overcome themselves, highlighting a considerable opportunity for an adviser to make a valuable difference. Approaches that an adviser could incorporate into his or her value proposition include helping the client to capture and analyse objective data about their investment decision-making and performance, providing tips and traps to help overcome key biased decisions, and (with permission) playing the role of the devil’s advocate.
These approaches can be complemented with investment strategies that combine the benefits of professional management with the continuing feeling of control for the client. For example, quarantine some investments for the client to manage themselves while the majority is professionally managed, or utilising a professionally managed investment structure that provides greater transparency, such as some separately managed accounts.
