One of the most common behavioural biases is the tendency to be overoptimistic. Like the children in Garrison Keillor’s Lake Wobegon who are all above average, we tend to overestimate our own skills and chances of success. This overestimation, in turn, leads to overly positive self-evaluations, which are often unrealistic – resulting in overconfidence.
Confidence is important. Michael Jordan said: “You have to expect things of yourself before you can do them”, and it is confidence which allows us to set these expectations and ultimately achieve them. Think of Muhammed Ali, who used to say he “never even thought of losing” as an example of pure self-confidence. Even for the truly mundane activities in our everyday life, confidence is important. However, it’s a double-edged sword!
Overconfidence has been blamed for a number of disasters ranging from the dotcom bubble in the 1990s to the sub-prime lending crisis which ended disastrously in 2008. Even the First World War and the war in Iraq have been blamed by historians and political scientists to overconfidence.
Overconfidence and optimism make for a lethal combination. They steer investors into a realm where they overestimate their knowledge, understate the risk, and exaggerate their ability to control the situation. The manifestation of this can arise in different ways, whether you overestimate the return you’ll earn, overestimate your ability to select a winning stock or fund manager, or over-trade, you could potentially be limiting your overall wealth.
In 1998, Terrance Odean found that overconfident traders will believe in a security more than they should and subsequently trade more than could be expected of the theoretical ‘rational’ trader. The result of this is that traders reduce their expected utility. Teaming up with Brad Barber in 2000 and 2001, they further found that households that traded the most (owing to their overconfidence) earned the lowest returns.
And let’s not forget that investors often use information taken directly from companies to assess whether their investments have any merit. Whether it’s drawn from the annual financial statements or a statement from the CEO, what makes us think that the CEO himself isn’t guilty of displaying this same overconfidence?
Adding fuel to this fire, humans also display a self-serving bias whereby we tend to attribute all the good stuff that happens to ourselves but project the bad stuff somewhere else. For example, you win a sporting match because you played well, but lose it because the referee was biased. Sound familiar?
In the realm of finance and investing we need to be weary of this. Be cognisant of your own inherent overconfidence as well as the overconfidence of those whose opinion and advice you might rely on. ❐
Author: Gizelle Willows CA(SA)