The Illusions That Make Investors Overconfident
You ever played the Madden NFL video game? For years, EA Sports put a top player on the cover. And then something funny kept happening. The cover athlete would have a terrible next season. Injuries, bad stats, team losses. Fans started calling it the Madden Curse. Some players actively tried to avoid being on the cover.
But here’s the thing. There was no curse. Chapter 13 of Burton and Shah’s book explains what was actually going on, and it has everything to do with how we fool ourselves about talent, skill, and our own abilities.
The Illusion of Talent
Every NFL player’s output in a given year comes from two things: talent and luck. Talent stays roughly the same from year to year. A fast running back is still fast next season. But luck changes constantly. The quality of teammates, the play calling, how defenses react, random injuries. All of this shifts unpredictably.
So when a player has the best season in the league, yes, he is very talented. But to finish at the very top, he also needed most of the luck factors to go his way. Next year, his talent stays the same, but the luck probably won’t repeat. His numbers drop. People call it a curse. It is actually just regression to the mean.
The same pattern shows up in golf. Kahneman found that golfers who shot way under par on day one of a tournament would do worse on day two. And golfers who had a terrible day one would do better on day two. Scores regress toward the average. Not because of nerves or overconfidence. Simply because extreme results require extreme luck, and luck doesn’t stick around.
And this is where confirmation bias kicks in. Believers in the Madden Curse remember every cover athlete who got injured. They forget that Larry Fitzgerald had a career year after his cover appearance. They forget Drew Brees had a stellar season right after being on the cover. Michael Jordan was on the Sports Illustrated cover 49 times and never suffered any measurable curse. But nobody remembers that part because it doesn’t fit the story.
We want to see patterns even in random processes. We want to believe that talent alone explains results. It doesn’t. Luck plays a bigger role than most of us are comfortable admitting.
The Illusion of Skill
Now take this idea and apply it to investing. The casual stock trader who thinks he can beat the market. The data here is brutal.
Burton Malkiel’s “A Random Walk Down Wall Street” showed that professional money managers are no more likely to beat market benchmarks than you are to call a coin flip correctly. Not slightly better. Not close. About the same as random chance.
Barber and Odean, two researchers from UC Davis, studied over 60,000 households and more than one million trades over six years. What they found is painful to read. On average, the stocks people sold went on to outperform the stocks they bought by 3.2 percent. Let that sink in. People would have done better doing the exact opposite of what they decided to do.
And the people who traded the most? They earned 11.4 percent annually. The market returned 17.9 percent over the same period. The more confident they were in their stock-picking ability, the more they traded, and the worse they did.
Kahneman looked at this from the professional side too. He analyzed 25 wealth managers at a firm over eight consecutive years. He ranked them each year and then checked if the rankings were consistent. The correlation between years was approximately zero. The manager who was best in year one had no better chance of being best in year two than any other manager. Zero persistence. Pure randomness dressed up in expensive suits.
And when Kahneman showed these results to the firm? Nobody cared. The managers got annoyed. The firm kept paying bonuses based on yearly performance. Everyone went back to doing exactly what they were doing before. Because admitting that your success is luck, not skill, is one of the hardest things a person can do.
The Illusion of Superiority
Here is where it gets really interesting. Most investment professionals will agree that the average person cannot beat the market. But ask them about themselves, and suddenly they are the exception. “Sure, most people can’t do it. But I can.”
This is the illusion of superiority. The short version: the average person thinks he or she is above average.
People remember their wins more easily than their losses. They rate their positive qualities as more important and their weaknesses as more common (so not that big a deal). Researchers ran experiments where people performed tasks in groups while observers watched. Then both sides rated the participants. The participants consistently rated themselves higher than the observers did. Every time.
This effect has several names in psychology. The “above average effect.” The “Lake Wobegon effect,” named after the fictional town where “all the children are above average.” But whatever you call it, the result is the same. People overestimate themselves.
In financial markets, this is dangerous. If you believe you are above average, you invest too much money based on your own judgment. You trade too often. You take bigger risks. And the data shows that, on average, this does not end well.
The Illusion of Validity
Kahneman tells a story from his time in the Israeli military. His job was to watch candidates perform a team exercise and predict who would succeed in officer training. He and a colleague watched soldiers try to get over a wall using a log, observed how they reacted under pressure, who got angry, who gave up, who stepped up to lead. After each session, they felt confident in their predictions. They were sure they knew who would make it and who would not.
Then the actual results came back. Their predictions were barely better than a coin flip.
And here is the kicker. After seeing the evidence that their predictions were useless, they went back and observed the next batch of candidates. And they were just as confident as before. The data said they couldn’t predict anything. Their gut said otherwise. The gut won.
This is the illusion of validity. People believe their conclusions from limited observations are more accurate than they actually are. And this belief survives direct evidence to the contrary.
Philip Tetlock, a psychologist at UC Berkeley, tested this on a grand scale. He asked over 200 professional forecasters to predict specific future events. Tens of thousands of predictions total. The result? The experts were less accurate than random guesses. Worse than chance. And when confronted with their failures, they had ready excuses. “I was right but the timing was off.” “I was wrong but for the right reasons.”
There is also a related idea called the illusion of control. People believe they influence random outcomes more than they actually do. If you roll the dice yourself, you feel like you have more control over the result than if someone else rolls them for you. When your prediction happens to be right, you take credit. When it is wrong, you blame bad luck. Heads I win, tails it wasn’t my fault.
Why This Matters for Your Money
All four illusions point in the same direction. People overestimate their ability to predict outcomes in financial markets. Individual traders think they can pick stocks. They can’t. Professional managers think they have an edge. Most don’t. And the people hiring managers can’t tell who is genuinely skilled and who just got lucky.
This has real consequences. Money flows to managers with flashy short-term records that could easily be explained by luck. Older, steadier performers with longer track records get ignored. Before the dot-com crash, investors poured money into tech stocks with amazing two-year returns and ignored decades of evidence about what reasonable returns look like.
The lesson from Chapter 13 is uncomfortable but important. Most of us are not as good at this as we think. The sooner you accept that, the better your financial decisions become. Index funds exist for a reason. And the reason is this chapter.
Previous: Causality and Statistics Traps in Investing