When it comes to investing, it’s best not to trust your memory, according to a new study co-authored by Philip Fernbach, professor of marketing in the Leeds School of Business at the University of Colorado Boulder.
The paper, published this month in the Proceedings of the National Academy of Sciences (PNAS), shows that investors tend to remember past investments performing better than they actually did. Investors are also more likely to remember winning investments than ones that lost them money.
“While there is a lot of academic research documenting this phenomenon––called overconfidence––among investors, and exploring its consequences, much less attention has been paid to why it is so prevalent,” Fernbach, who co-directs Leeds' Center for Research on Consumer Financial Decision Making, said.
The study is the first of its kind to scientifically measure investor overconfidence. Overconfidence means a person’s subjective confidence in their ability is greater than their actual performance.
Working with Daniel Walters, a professor of marketing at INSEAD, Fernbach surveyed real investors in a series of surveys that examined how participants remembered their most consequential trades. The study also assessed their overconfidence and trading frequency.
Those surveyed answered questions from memory about their most significant trades, both winners and losers. The researchers compared their answers to the true performance of those trades by reviewing participants financial statements.
“We found that investors consistently recalled their trading performance as better than they actually achieved,” Fernbach said.
The results confirmed what professionals in the financial industry have suspected for years: Biased memory may play a role in overconfidence.
Fernbach and Walters discovered two types of memory bias among investors: “distortion,” in which investors remember their returns doing better than they actually did; and “selective forgetting,” a tendency for investors to fail to remember their losses.
Not only did the study suggest that investors display memory bias when recalling investments, it also showed that participants with greater memory bias were more overconfident and traded more frequently. The researchers said this further suggests that biased memory may directly contribute to overconfidence.
While the results may be surprising for some investors, whose overconfidence can literally cost them money, overconfidence is a common feature of human behavior. Fernbach, who earned his PhD in cognitive science, studies how people think and applies his research findings to help people make better decisions.
“Overconfidence is one of the most prevalent and important decision-making biases,” Fernbach said. “Our work is the first to connect overconfidence to biased memory about the past.”
To curb memory bias, Fernbach and Walters agree there is a simple solution: Rely on the hard data. Instead of trusting your memory, look at past financial statements to inform your next investment.
This method proved successful in the study's third exercise: Fernbach and Walters compared investment habits of participants who were able to review their returns beforehand to those who invested based off memory. Those who looked up their history before investing were less overconfident.
The researchers said that other safeguards can be put in place to curb investor overconfidence. For example, brokers can help by displaying prior returns on their trading platforms. Policymakers could require financial institutions to provide customers with past return information on a regular basis.
“The implications of our research are clear,” Fernbach said. “When it comes to investing, don’t trust your memory.”