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The Risks of Overconfidence

“A man’s got to know his limitations”, the final words uttered by Clint Eastwood in Magnum Force, right after the last villain was dispatched.

They’re also the words every investor should consider before confidently leaping into any new investment.

If you’re really confident on your next investment, ponder the following:

Warren Buffet’s company, Berkshire Hathaway, had a 2.4% higher annual return than US shares from 1991 to 2011.

If arguably the best investor out there can only expect to outperform the market by a couple of percentage points per year over two decades, why does the average investor still think they can continually hit investment home runs?

As Buffett says about Berkshire Hathaway’s investing competence, “I guess you’d say we have a strong sense of our own limitations”.

Over the short term, home runs can be had, but there’s a reason individual investors eventually fall behind the returns of the market – luck is often confused with skill.

Everyone knows someone who has had a great success story on a share, riding it from a few cents into the dollar range.

A local example of this was Allegiance Mining.

There are plenty of stories of local investors getting into Allegiance at double cent levels and riding it to the eventual takeover price of $1.10 in mid-2008.

From that point, many investors confident on their recent success were putting those Allegiance profits into the next hot mining company.

While only anecdotal, I’ve not heard much chatter about how those investments turned out.

The silence suggests some of those profits searching for the next hot thing were soon surrendered.

This is backed up by data from the ASX Small Ords and ASX Metals & Minerals indices.

Declines of 30% and 45% respectively, suggest there haven’t been many outperforming small miners or outperforming miners in general, since Allegiance’s takeover.

Highlighting the problem with buying individual shares, picking a winner or two can quickly have us believing our success was more skill than luck, leading to overconfidence and losses in the future.

Good investors know their limitations; bad investors, like movie villains, ignore their limitations completely.

Peter Mancell is a director of Mancell Financial Group and FYG Planners AFSL/ACL 224543, www.mfg.com.au This information is general in nature and readers should seek professional advice specific to their circumstances. Wondering who to trust with your financial affairs? We ‘re one of six fiduciary financial planners in Australia.