What is overconfidence?
Behavioral finance is a concept that has its roots in the 1970s-80s from psychologists Daniel Kahneman and Amos Tversky, combining the complex world of finance with the equally puzzling human psyche. Although behavioral finance is a very well researched topic nowadays, covering many different activities relating to portfolio management and business, it is still a new subject needing further research.
More specifically, behavioral finance studies the impact of cognitive biases on our financial decisions. The overconfidence bias is one of them which has a particularly strong impact.
Overconfidence refers to the tendency of individuals to have an inflated sense of their own abilities, knowledge, or performance in various tasks or domains. It is a cognitive bias where people believe that they are more competent, capable, or accurate than they actually are. This bias can lead individuals to overestimate their skills, underestimate risks, and make poor decisions based on an overly optimistic view of their abilities.
Two main dimensions of overconfidence
There are two main aspects of overconfidence:
- Overestimation of Abilities: Individuals often believe that they are more skilled or knowledgeable than they truly are. This can lead to situations where people overestimate their capacity to perform tasks, solve problems, or make accurate predictions.
- Underestimation of Risk or Error: Overconfidence can also manifest as underestimating the likelihood of making mistakes or experiencing negative outcomes. People might take on more risk than they should because they believe they are less likely to fail than they actually are.
Overconfidence bias in finance
In the financial area, this leads people to invest in assets they are familiar with, which subsequently means their portfolios are less diversified than someone who does not suffer from the same bias, causing their portfolios to be more risky and more likely to suffer losses. (Ritter, 2003)
Another trait of overconfident investors is excessive trading. Where the rational investor will only make an investment in instances where the profits outweigh the transaction costs, the irrational overconfident investor will overestimate their knowledge and make investments that end up being net negative. In addition, an overconfident investor who trades excessively, will naturally also accumulate a larger sum in transaction cost, eating up their potential profits.
Another interesting spin on this theory is that men are more affected by this bias than women. Because men tend to display more overconfidence than women, they also trade more and therefore will perform worse than women. (Barber & Odean, 2001)
Overconfidence bias is something that is noticeable also outside of investing, affecting our daily cognitive tasks. It can affect us in many ways, both in how we think and subsequently also how we act. A classic example of how overconfidence bias affects our thinking is a study showing that 93% of American drivers believe they are a better than average driver, which of course is not statistically possible (Nikolopoulou, 2023) . This can of course also be applied to finance and investing, where the majority of market analysts regard their analytical skills to be above the average, which again is impossible according to statistics (Corporate Finance Institute, 2023) .
How to mitigate the overconfidence bias?
- Self-awareness: Recognize that overconfidence is a common cognitive bias and be mindful of situations where you might be prone to it.
- Seek Feedback: Solicit feedback from peers, mentors, or experts to gain a more objective perspective on your skills and decisions.
- Encourage Critical Thinking: Cultivate a habit of critically evaluating your own assumptions, decisions, and actions. Consider alternative viewpoints and potential risks.
- Embrace Humility: Recognize that nobody is immune to mistakes or errors in judgment.
- Embrace a sense of humility and openness to learning from failures.
- Diversify Information Sources: Seek a wide range of information and opinions to avoid being overly influenced by your own biases.
By being aware of the overconfidence bias and actively working to counter its effects, individuals can make more informed and rational decisions, leading to better outcomes in various aspects of their lives.