The perils of overconfidence

David MoonBlog

A recent study from Charles Schwab reaffirms what you have read multiple times but might still be tempted to test. Even if you could repeatedly guess the best time to invest your money into the stock market, the benefits of doing so are minimal, especially when compared with a simple system based on historical probabilities.

The Schwab study looked at the past 20 years and assumed an investor had a new $2,000 available to invest on January 1 each year. If that hypothetical investor was brilliant and could identify the stock market’s lowest point each year and invested his $2,000 on that date, he would have accumulated $138,000 over those 20 years.

But if an investor simply put his money into the stock market on the first day of each year, the results were shockingly similar. He would have accumulated $128,000 over those 20 years. Simply buying on January 1 generated a 10.9% annual return, versus 11.6% for the investor who guessed right 20 consecutive times.

What the Schwab study does not say but I will: you cannot guess correctly 20 consecutive times. There are about 250 trading days each calendar year. The odds of picking the lowest day out of 250 are very low. The odds of then doing it another 19 times are essentially impossible.

So why do so many people try?

It’s probably a combination of things. Money and emotion are, for many people, inextricably linked, and emotion is seldom helpful when trying to make rational decisions. It is also likely that people suffer from overconfidence, especially if they have good luck early in an activity or process. Success often leads individuals to overlook the possibility of failure especially when they have confused luck with skill.

Overconfidence bias is a trait inherent in human nature. Surveys find that people commonly overestimate their skills and strengths. Eighty percent of people think they have an above average IQ, about the same percentage who rate themselves as above average drivers. Seventy-four percent of investors rate themselves as above average, while 25% rate themselves as average. Only 1% of investors realize they are below average and are willing to admit it.

Why does investing on the first day of the year produce results almost as profitable as accurately guessing the best day each year to invest? Because the stock market increases an average of about 10.5% a year, which translates to a long-term average of a little less than 1% a month. Waiting to invest your money costs you an average of 1% each month you procrastinate.

It’s a pretty simple observation – one that an overconfident person is quick to dismiss.

David Moon is president of Moon Capital Management. A version of this piece originally appeared in the USA TODAY NETWORK.