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We all tend to favour things that we understand. After all, if we don't understand, how do we know it's a good investment? This is often referred to as the "investing in what you know" strategy, and for many people, it seems like a safe way to go. However, there are several dangers associated with this approach. In this column, I'll discuss some examples of falling in love too much with investments that we feel we know well. We’ll also cover the idea of overconfidence bias and why investing in what you know can be risky business.
Real estate
In 1982, I worked in a department store during a gap year in university. Clueless about finance at the time, the only thing I knew was what I learned from my parents: “save your money!” I saved most of every paycheque I received into term deposits for the following year’s university tuition. I was so thrilled that interest rates kept going up every time I deposited money!
The people paying for those high-interest rates were not as thrilled! I think you know the rest of the story. Mortgage lending rates topped out at over 20 per cent, forcing many real estate investors to foreclose, unable to make their payments. Home values plummeted across the country. It was a bloodbath that too few people remember. Did these real estate investors know their investments? Absolutely! Were they able to tell the future? Absolutely not.
Technology and telecommunications
Fast forward to the late 1990s. We were well into the age of the microchip, personal computers, and the beginnings of the internet. I distinctly remember people employed in the technology sector who, drunk with overconfidence, started investing on their own in technology stocks. People even mocked investors like Warren Buffett, regarding them as out of touch with the times. Then came March 2000 when the whole house of cards collapsed. Did these investors know their investments? Intimately at times! Could they tell the future? Not at all!
Construction projects
How many of us have had a contractor give us an estimate of the time required to do a home renovation and see the project timeline double or quadruple? That’s the overconfidence effect!
The Boston Big Dig runs through the heart of Boston and was originally scheduled to complete in 1998 at a cost of 2.8 billion U.S. dollars. The project ultimately finished 8 years behind schedule at a cost of 15 billion dollars, over five times the original budget!
The amazing Sydney Opera House was originally estimated to complete in 4 years at a cost of AUS $7 Million. It ultimately took 14 years and AUS $102 Million – 14.5 ties the original budget!
Investor, know yourself!
When we're too confident in our investments, we may overlook potential risks and dangers that could crop up down the road. This can lead to us making poor decisions with our money, such as selling off investments at the wrong time or not diversifying enough.
In short, it's important to be aware of the overconfidence bias and to be careful not to let our emotions get the best of us. After all, investing is a long-term game, and it's important to stay level-headed if we want to achieve success.
In the same way that you turn to your doctor, lawyer, or accountant for professional advice, you need a financial guide by your side to help you keep emotions in check and test your investment strategies based on science and logic, rather than feelings.
Richard Vetter is a Certified Financial Planner and owner of WealthSmart Inc.
