The Overconfidence Trap

I started my career in finance around the time of the 2008 financial crisis. Confidence was hard to find.

I met retirees who had watched their savings evaporate in a matter of months. Some questioned whether they could afford to retire. Others wondered whether they could stay retired. I saw people shed real tears as the future they had worked toward suddenly felt out of reach.

Those conversations have stayed with me. They taught me how quickly market conditions can change the way people feel about their money.

Recently, some of my conversations with investors have felt very different. Years of strong returns and excitement around artificial intelligence have created a sense of possibility. In some cases, that confidence has started to look like complacency.

I understand the optimism. Investors who stayed invested through difficult periods have seen their patience rewarded quicky with V-shaped recoveries. But a good experience in the market can also make us more comfortable with risk than we realize.

That is where the overconfidence trap begins.

When confidence grows

After an investment has performed well for years, it becomes easier to imagine more of the same. A company starts to seem unstoppable. A sector feels like an obvious place to invest. A strategy that benefited from favorable conditions begins to look dependable in any environment.

We may even start confusing a strong market with our own investing skill.

That can change how we make decisions. We become more willing to add to a winning position, concentrate in a few companies, or brush aside concerns we would have taken seriously a few years earlier.

Sometimes, we take on more risk with only the potential reward in mind. We allow a handful of investments to grow to represent a much larger share of the portfolio than we originally intended.

The question is whether that portfolio still fits the financial plan.

If your retirement goals, spending needs, and ability to absorb losses have not changed, a rising market alone is a poor reason to become more aggressive. Feeling certain about an investment does not make it less risky.

Fear can pull us off course, too. I saw that during the financial crisis, when investors became convinced that conditions would never improve. A prolonged stretch of strong returns can encourage the opposite assumption.

Confidence cuts both ways, and either having too much or too little can lead an investor into making detrimental decisions for the retirement plan.

Why retirement changes things

Overconfidence becomes especially important as you approach retirement. You may be growing more comfortable with investment risk just as your portfolio needs to begin supporting your lifestyle.

During your working years, you are generally adding money to your accounts. A market decline may allow your ongoing contributions to buy more shares at lower prices.

Once you begin taking withdrawals, the circumstances change.

If markets fall early in retirement, you may need to sell investments at depressed prices to cover expenses. Those withdrawals leave fewer assets available to participate in a recovery. Even if markets eventually rebound, the money you withdrew is no longer invested.

This is what we call sequence-of-returns risk. The order of your returns matters when money is coming out of the portfolio.

Two retirees can experience the same investment returns in a different order and have very different outcomes if they are taking withdrawals along the way. Early losses can put greater pressure on a portfolio because spending continues while its value is down. Here’s an example looking at a hypothetical $1,000,000 portfolio withdrawing $60,000/year that experiences the same average return but in a different order.

Both retirees withdrew $600,000 over the decade. The retiree who experienced strong markets first finished with approximately $406,000 more.

That is why an expected average return tells only part of the story. A retirement plan also needs to account for withdrawals, near-term spending, other income sources, and the ability to adjust when conditions change.

It also needs to account for you.

How would you react if your portfolio fell sharply during your first few years of retirement? Could you stay with the plan? Would you feel compelled to sell? Would you have enough flexibility to reduce withdrawals for a while?

Those questions are easier to work through before a downturn, when you have time to consider your options without the pressure of watching your account balance fall.

Keep your perspective

When I was younger, someone told me to invest like Björn Borg played tennis. Take the highs and lows in stride and keep your emotions from taking over.

I have always liked that advice.

Winning a few points does not mean the rest of the match will be easy. Losing a few does not mean the match is over. What matters is maintaining your composure and staying focused on the game plan.

Investing takes a similar kind of discipline.

You will feel encouraged when your portfolio rises and uncomfortable when it falls. That is normal. The challenge is keeping those feelings from making decisions for you.

A strong market is a good time to revisit your plan. Look at how your holdings have changed. Consider whether a few positions now account for too much of your portfolio. Review whether the amount of risk you are taking still makes sense for the income you will need.

There is no need to wait until you feel worried to have that conversation.

Stick with the plan

As advisors, our job is to act like thermostats rather than thermometers. A thermometer simply tells you the temperature in the room. A thermostat helps adjust it.

When markets are rising and enthusiasm is running high, our role is to temper that excitement and keep risk in perspective. When markets are falling and fear takes over, we help clients look beyond the immediate discomfort and recognize opportunities that may fit their plan.

That means offering perspective even when it goes against the mood of the market.

We monitor portfolios, rebalance when appropriate, and review positions that have grown beyond their intended role. We also revisit spending needs and income sources so investment decisions remain connected to the broader retirement plan.

Sometimes that leads to changes while markets are strong and everyone feels comfortable. Those decisions can be difficult when the investments being trimmed have performed well. Still, managing risk requires looking beyond what has worked recently.

We cannot tell you when the next downturn will arrive or how severe it will be. What we can do is help prepare a plan that accounts for difficult markets and gives you a clearer sense of what to do when they come.

Enjoy the progress a strong market has helped you make. Take the vacation. Spend time with your family. Appreciate what your savings have made possible.

Just make sure your portfolio still reflects your retirement needs.

Like Borg, take the highs and lows in stride. Stay focused on the plan.

Disclosures

This material has been prepared for informational purposes only and should not be construed as a solicitation to effect, or attempt to effect, either transactions in securities or the rendering of personalized investment advice. This material is not intended to provide, and should not be relied on for tax, legal, investment, accounting, or other financial advice. You should consult your own tax, legal, financial, and accounting advisors before engaging in any transaction. Asset allocation and diversification do not guarantee a profit or protect against a loss. All references to potential future developments or outcomes are strictly the views and opinions of Richard W. Paul & Associates and in no way promise, guarantee, or seek to predict with any certainty what may or may not occur in various economies and investment markets. Past performance is not necessarily indicative of future performance.