Overconfidence Bias: Overview
Overconfidence bias is a cognitive bias that can negatively affect investment returns by leading people to overestimate their skill and knowledge, trade too frequently, incur higher costs, or ignore relevant information and feedback. Because of this bias, investors can make poor financial decisions.
We will explore the concept of overconfidence bias, its impact on finance and investing, and how to avoid falling prey to this cognitive trap.
Key Takeaways
- Overconfidence bias is a cognitive error that leads individuals to overestimate their abilities and knowledge, leading to poor decision making.
- In finance and investing, overconfidence bias can result in excessive trading, under-diversification, and taking excessive risks, among other pitfalls.
- Behavioral economists suggest that overconfidence bias can be diminished byseeking objective feedback, considering contradictory evidence, and sticking to a trading plan.
- Recognizing and understanding overconfidence bias is crucial to making better financial decisions and improving investment returns.
Understanding Overconfidence Bias
Overconfidence bias is a cognitive bias in which individuals tend to overestimate their abilities, knowledge, and skill in a particular area, leading them to make errors in judgment and decision making. This overestimation can manifest itself in various ways, such as an inflated sense of control, unrealistic optimism, or underestimating the risk involved in a situation.
Most people tend to believe that they are above average: more intelligent, more honest, or that they have a brighter future than the average person.For example, researchers have found that 73% of U.S. drivers claim to be better than average, which is statistically impossible (because exactly half would be better than average). Because of this natural human tendency, our judgment is highly susceptible to overconfidence bias.
Overconfidence is, therefore, one of the most common issues found in financial decision making. It is also a very serious flaw, as it reinforces other problems, such as hindsight bias, attribution bias, and self-serving bias. Excessive faith in beliefs and abilities makes it harder for us to see just how prone we are to errors and biases. It also leads us to discount or ignore our mistakes and instead assign blame to others or to things that are outside of our control.
Sixty-five percent of Americans surveyed reported themselves as being of above-average intelligence.
Overconfidence Bias in Finance, Trading, and Investing
Understanding the direction of markets is one of the most important skills in finance and investing. In this industry, many investors, traders, and even professional analysts consider themselves to be above average in their ability to predict the direction of markets.However, as with drivers, it is a statistical impossibility for most analysts to be above average or to predict the direction of markets accurately.
The danger of overconfidence is that it can lead people to take larger positions in the market than is wise and, as a result, lose money much more quickly. This is because overconfidence tends to make us firmly committed to our investment decisions, even when they are incorrect.
Research has shown that overconfident investors tend to trade more frequently, resulting in higher transaction costs and lower returns. Moreover, overconfident people often underestimate the risks associated with certain investments, leading them to take excessive risks or invest in high-risk assets without properly assessing the potential consequences. They also can construct poorly diversified or concentrated portfolios. They may ignore warning signs based on their normalcy bias that everything will remain the same.
Risks of Overconfidence Bias in Trading
- Excessive trading: Overconfidence can lead investors to trade more frequently than necessary, resulting in higher transaction costs and potentially lower investment returns.
- Under-diversification: Overconfident investors may believe they can accurately predict market movements, leading them to concentrate their investments in a few high-risk assets rather than diversifying their portfolio.
- Underestimating risk: Overconfidence can cause people to underestimate the risks associated with certain investments, exposing them to potentially avoidable financial losses.
- Ignoring contradictory evidence: Overconfident traders and investors may downplay or dismiss information or evidence that contradicts their original decision, leading them to maintain positions in poorly performing investments and fall victim to confirmation bias.
Note
Industry surveys of financial advisors report that millennials are the most overconfident generation of investors, with two-thirds of this cohort regularly displaying overconfidence—compared with just one-third of Gen-Xers and one-fifth among older generations.
Types of Overconfidence Bias
Illusion of Control
The illusion of control occurs when people believe they have more control over outcomes than they actually do. In investing, this can lead to overestimating one’s ability to predict or influence market movements. For example, some investors may think they can time the market or predict its movements based on their intuition or past experience. However, the market is often influenced by random events or factors beyond our control.
Illusion of knowledge is closely related; it refers to the belief that we have more information than we actually do, and that this information will improve our accuracy. For example, some investors might rely on complex models or technical indicators that give them a false sense of certainty. Indeed, more information doesn’t necessarily mean better information or better decisions.
Optimism Bias
Optimism bias occurs when someone overestimates the likelihood of positive outcomes and underestimates the likelihood of negative outcomes. In finance, this can result in underestimating the risks associated with specific investments.
Optimism bias can play out as overestimation, or the tendency to positively overestimate our own abilities or performance relative to others or vs. an objective standard.
Miscalibration
Miscalibration refers to the tendency to be overly confident in the accuracy of one’s predictions, leading to a disconnect between the individual’s perceived and actual abilities. In investing, this may cause investors to trust their own predictions more than they should.
Miscalibration can take the form of overprecision—for example, we may think we know the exact value of a stock or exactly how much a stock will rise or fall based on an earnings announcement.
How to Avoid Overconfidence Bias
- Seek diverse opinions: Consult with others and consider diverse perspectives before making financial decisions to avoid relying solely on your own judgment. Especially seek out contradictory evidence or opinions.
- Continuously educate yourself: Stay informed about market trends, new investment opportunities, and relevant research to keep your knowledge current and help counteract overconfidence.
- Keep an investment journal: Maintaining a record of your investment decisions, the reasons behind them, and their outcomes can help you evaluate your past performance and identify areas for improvement.
- Set realistic expectations: Remind yourself that no one can predict market movements with absolute certainty, and be prepared for the possibility of losses as well as gains in your investments.
- Practice self-awareness: Regularly assess your confidence levels and question your beliefs, assumptions, and biases to keep them in check and prevent overconfidence from clouding your decision making.
- Emphasize risk management: Focus on managing risk in your investment strategy rather than trying to maximize returns. By considering worst-case scenarios and potential losses, you can create a more diversified and resilient portfolio, which may help to counteract overconfidence.
- Systematic decision making: Adopt an objective, structured approach to decision making that incorporates both quantitative data and qualitative analysis—and then stick with it. This can help to minimize the influence of cognitive biases, such as overconfidence, and lead to more-informed and rational financial decisions.
- Recognize the role of luck: Acknowledge that luck plays a role in investment outcomes and that success may not always be solely attributed to your skills or knowledge. Recognizing the role of luck can help you maintain a humble perspective and reduce the risk of overconfidence bias.
What Causes Overconfidence Bias?
Overconfidence bias is primarily cognitive, as it involves an individual’s thought processes and ability to make judgments. Some of the cognitive factors that contribute to overconfidence are thought to include heuristics, which are unconscious cognitive frameworks that humans have built up over time to simplify and speed up our daily decision making, and biases that lead people to systematically deviate from rationality or objectivity. False beliefs or impressions that aren’t based on evidence may also come from memory errors or selective recall of past events or information.
What Are the Signs of Overconfidence?
An overconfident trader may engage in excessive trading or frequently change their investment strategies, believing that they can outsmart the market. Another sign could be that they disregard or downplay risks associated with certain investments, thinking they can handle anything that comes their way. Overconfident individuals may also have a tendency to ignore advice or feedback from others, as they believe their own judgment is superior.
What Is the Opposite of Overconfidence?
The opposite of overconfidence bias is under-confidence or self-doubt. Under-confidence occurs when a person underestimates their abilities, knowledge, or skills, leading to hesitation, indecision, or avoiding risks that might otherwise be beneficial. One example of this is imposter syndrome, whereby high achievers begin to doubt their abilities.
What Is the Difference Between Overconfidence Bias and the Dunning-Kruger Effect?
The Dunning-Kruger Effect is a specific instance of overconfidence bias that occurs when people with low ability or knowledge overestimate their actual competence, while people with high ability or knowledge can underestimate their competence. With this effect, people with low ability or knowledge lack the cognitive skills to recognize their own limitations or errors and proceed (mistakenly) with high confidence—often leading to failure.
The Bottom Line
Overconfidence bias occurs when we overestimate our own knowledge, skills, and abilities. Overconfidence can have significant negative consequences on your investment returns by leading you to make poor financial decisions. Recognizing and understanding this cognitive bias is essential for improving your decision-making abilities and ultimately enhancing your investment performance.
By using strategies to reduce overconfidence, such as seeking diverse opinions, continuous learning, and practicing self-awareness, you can make more-informed financial decisions and avoid the pitfalls of overconfidence bias.
