The overconfidence effect is a well-establised bias in which someone’s subjective confidence in their judgments is reliably greater than their objective accuracy, especially when confidence is relatively high. For example, in some quizzes, people rate their answers as “99% certain” but are wrong 40% of the time.
Overconfidence has been called the most “pervasive and potentially catastrophic” of all the cognitive biases to which human beings fall victim. It has been blamed for lawsuits, strikes, wars, and stock market bubbles and crashes.
In a 2006 study entitled “Behaving Badly”, researcher James Montier found that 74% of the 300 professional fund managers surveyed believed that they had delivered above-average job performance. Of the remaining 26% surveyed, the majority viewed themselves as average. Incredibly, almost 100% of the survey group believed that their job performance was average or better. Clearly, only 50% of the sample can be above average, suggesting the irrationally high level of overconfidence these fund managers exhibited.
As you can imagine, overconfidence (i.e., overestimating or exaggerating one’s ability to successfully perform a particular task) is not a trait that applies only to fund managers.
Overconfidence in Investing
In investing, overconfidence can be very hurting in the long run. Overconfidence investors and traders tend to believe they are better than everyone else in choosing best stocks and funds etc., and even better times to enter and exit a position.
Overconfidence is tendency to place an excessive degree of confidence in one’s ability in making decisions.
That is believing that we are better and wiser than others in choosing investments than we actually are.
This often leads to swifter decisions that the investor later regret.
This bias usually happens when an investor tastes a few easy successful investments. They don’t realise that they were just lucky those few times. Instead, they start believing themselves and think they have the capacity better than others in selecting winning investments.
A rising tide raises all boats. Similarly, a rising stock market also increases the confidence of investors. Overconfidence can be easily mistaken for good skill and talent.
Dangers of Overconfidence Bias
- Overconfidence causes traders and investors to get in and out frequently in the markets taking risky bets
- Traders think they can control their portfolio as per their wish as they believe they are always good
- People overestimate the accuracy of their information
- They don’t take any contradicting arguments with their holdings as they believe they have necessary skills
- News and Information flow during bull markets add fuel to the fire
- Avoiding diversification as they believe having excellent stock picking skills
- Check if you are driven by a few bets which have rewarded handsomely and whether you have done proper analysis of the business before investing in them
- Sticking to strict risk management rules
- Check if you are trading frequently
- Are ready to take blame on your part of wrong investing decisions
- Are you self-aware of your investment bet skills and limitations
My experience with Overconfidence Bias
During the stock market boom of 2005 -07, I was investing in companies of Capital goods, Infra and Power sector, and fortunately those stocks were rallying sky high. I invested in companies like Reliance Energy, L&T, BHEL, BEML, Tata Power to name a few. I was really confident that I was having enough skills and expertise in picking stocks, because, whatever I picked up went up almost daily. I was also entering into few hot IPOs.
Then when the tides turned in Jan 2008, my portfolio suffered. I realised that the financial meltdown in 2008 is severe and sold off my entire portfolio at a loss – I was fortunate to sell at a smaller loss as I exited early.