Overconfidence Bias: Are you as smart as you think?
Created on 20 Sep 2020
Wraps up in 4 Min
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Updated on 31 Jan 2024
Good character can often be undermined by overconfidence. For instance, most of the investors, mainly when they are new to the investment world, are very overconfident. Overdoing anything has consequences. Overestimating your appetite and ordering too much food leads to a lot of wastage of food. Over-sourcing, your dinner ruins the taste.
Similarly, overconfidence might destroy your investments. Being confident is essential, but so is knowing your limit.
In a way, this is your caliber, which is having a fling with every opportunity which is there in the market. Taking every opportunity that comes it's way, diving in and not weighing up the risk and the rewards properly; this could lead to a lot of confusion about what is the result of investing versus the risk. This may lead to blowing up a lot of wealth.
In his book 'The social animal,' David brooks wrote that human minds are overconfident machines, and the psychological literature bears that out.
Let's understand this with an example. A survey was conducted where different groups of people were asked to answer the question, "Are their driving skills better than the average drivers?"
The majority of people were overconfident about their driving skills and said that they are better than average drivers.
Overconfidence bias is not only found in traders, but it also goes up to the fund managers. In a survey of 300 professional fund managers, it was asked how many of them believed that they are above average in their jobs? Around 74% of them said yes and believed they are above average in their job. This shows they might be suffering from overconfidence bias.
What is overconfidence bias?
Confidence is good, but overconfidence may lead an investor to misjudge his investment beliefs and opinions. There is a lack of balance under the confidence effect. People tend to systematically overestimate their skills and knowledge by trying not to underestimate them. This is known as the overconfidence bias.
You may not be surprised that men are more prone to overconfidence than women. Women also tend to overestimate their knowledge and skills, but often less strongly than men.
Thus, overconfidence bias is a bias in which a person tends to overvalue their ability and understanding of any situation than is objectively reasonable. It might lead to the drainage of wealth if investors do not prepare themselves before investing.
For example, Answer this question.
How confident do you regard your ability to choose stocks that outperform Nifty50?
If you have greater confidence, that means you are suffering from certainty overconfidence.
This overconfidence also involves matters of character. Due to overconfidence, people simply assume that they have good character, and they, therefore, will always do the right things. For instance, in our previous example, the employees were overconfident about their ethics in the workplace.
Impact of overconfidence bias on your investment decisions
Overconfident investors do not prepare themselves for any kind of uncertainty because they are overconfident about their predictions.
- Overconfidence of investors generally misleads them, and they tend to ignore the actual risk involved in the investments because they often give less importance to their prediction window.
- Investors suffering from overconfidence usually believe that their choice of investment avenues is right, but this can often lead them towards low returns from their investment.
- Generally, overconfident investors do not diversify their portfolios much. This may expose them to a higher risk. Investors blindly believe in knowledge and the ability to bet on concentrated stocks, and that is the reason they underestimate the downside risks and hold on to undiversified portfolios.
- When investors are overconfident about their investment decision, they often tend to ignore important information and oversee any information which contradicts their decision. Overconfident investors often overestimate their ability to evaluate a company.
- Investors suffering from overconfidence bias believe in their ability to get in and out of stock, and that's why they go on trading excessively.
How to overcome the overconfidence bias in your investment decision?
- Be aware that you tend to feel more certain about an investment future than it is. This means you tend to take more risks than you think you are taking. Investors should always add an extra margin of safety to their decisions. This margin can be called the overconfidence margin.
- Be just the spectators of predictions, especially from the market experts. Do not follow them blindly. If you look at the forecast's history, it's amazing how wrong most of them were. Think and forecast for yourself and then adjust your confidence.
- With all plans, favor the pessimistic scenario that gives you a chance of judging a situation realistically to some extent.
- Read history. Stock market history, economic history, plain old political history. Even better, read a 25-year-old newspaper. Read the market comments in the business section. You will see that the world is highly unpredictable. Almost nobody got it right. Don't think that you will be an exception.
The Bottom Line
Have you ever looked around yourself and thought, how many restaurants are there in your locality? And how many of them survived for more than five years? Well, most small businesses like a cafe or a restaurant are not able to survive even for a year. But we keep seeing new ones opening up now and then. This is a very classic example of overconfidence bias.
We all systematically overestimate our knowledge and our ability to predict big-time. It is normal, but if investors can correct this thinking error by being more conscious and adding an extra margin of safety to their financial decisions. As an investor, you should study your investment decisions thoroughly.
Only the self-awareness of this bias and then reviewing your investment decision can help you to avoid this bias to some extent. Investors should again try to resist their feelings and intuition to make more rational decisions. At last, knowing when not to trade can be even more important than catching a big trade that makes you a fortune. Life can surprise you, and so can markets.
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