Are You “Money Smart?”

At one of my recent talks on the psychology of money, I was asked, “What is the most common psychological error people make (in managing their money?”) The word “fear” popped into my mind. While not an error, per se, fear can be a driving force behind money decisions that may not turn out as planned. After a moment’s thought, however, I realized that an equally challenging factor is the tendency toward overconfidence.

In their book, Why Smart People Make Big Money Mistakes, Gary Belski and Thomas Gilovich state: “Numerous studies over the years have demonstrated significant overconfidence in the judgments of doctors, lawyers, engineers, psychologists, and securities analysts.” According to these findings, highly educated people seem to see their “smarts” in one area as evidence that they are more knowledgeable in other areas as well. But it’s not just professionals who fall prey to this belief. It appears to be part of human nature generally to over-estimate our abilities. For instance, in rating our skills at driving, how many of us think we are “smarter than the average bear?”

Easy access to vast amounts of information plays a part, too. A ten minute search on the internet, followed by advice from a friend who “knows something” about the subject we’re researching, can lull us into thinking we’re making an informed decision about something we actually know very little about.

What are the implications for our personal finances? Choosing investments is one situation where overconfidence can lead to pitfalls. Consider the example of solar energy. You hear of a mutual fund that invests in alternative energy or even an exchange-traded fund that invests exclusively in solar. You believe this is a huge opportunity! At the time, oil prices are high and solar stocks are doing well. Months later, oil prices plunge and the federal government withdraws some of its subsidies for solar. The stock prices tank. Suddenly you’re down fifty percent, yet you were certain this would be a great investment.

Another important aspect of personal finance vulnerable to overconfidence is our assessment of how prepared we are for retirement. When times are good, we can’t help but feel we’ve got it covered. I’ve encountered plenty of people passing through my office who don’t have financial plans, but still think they’ll be ready for retirement when the time comes.

There’s nothing wrong with having confidence and optimism. However, we need to be aware of our tendencies and how these may color our perceptions and actions. We often think we’re smart about certain subjects and therefore believe that we possess superior insight when it comes to others. A quick search of the web can make us overconfident, for instance, in picking individual stocks and mutual funds. It can convince us we’re more prepared to retire than reality would suggest.

We also need to recognize the fact that our interpretations of past events can be quite selective. If an idea turns out as we predicted, we attribute the success to our own high ability. If it fails, we tend to blame the outcome on some other cause over which we had no control. We maintain our confidence that better luck and/or a better analysis will ensure a more favorable result next time.

A little knowledge can be dangerous. On the other hand, a little self-knowledge can be powerful!

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