Beware the Better-Than-Average Effect

We’re always hearing about the “average” person. You know, the one who is 36.7 years old, graduated from high school but probably not from college, earns between $33,000 and $62,500 per year in a white-collar job, owns a three-bedroom home worth about $167,000, has 1.86 children, eats 160 pounds of sugar every year, and will live to be 78.1 years old.

That doesn’t sound like you, does it? And if it seems to you that it wouldn’t take too much effort to distinguish yourself from the average American, well, then, you are average, too.

Economists have found that, on average, people tend to believe that their own lives are improving at a faster rate than most everyone else’s. This phenomenon, dubbed the better-than-average effect, shows up in studies in which individuals are asked to rate their own personal well-being and the well-being of the country.¹

Research suggests that this belief may cause investors to become overconfident, leading them to underestimate risk, trade in riskier securities, overreact to private information, underreact to public information, and trade more aggressively in periods after they observe market gains.²

Basing your financial strategy on inflated expectations could be a costly mistake. Imagine planning for a 12% return from a portfolio that actually yields only 6%. This type of overconfidence may cause you to save too little or spend too much. Adopting a more conservative outlook may encourage more disciplined saving. If your portfolio outperforms your expectations, you may reach your goals sooner than expected.

1–2) Federal Reserve Bank of St. Louis Review, May/June 2009

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