The study of behavioural finance has proved that psychological influences and biases affect the behaviour of investors. Behavioural finance explains how investors think and the repercussions of their decisions on the market. In this article, we shall be looking into one such behaviour bias of investors- the overconfidence bias.

Overconfidence bias is exactly what it sounds like. The investor tends to hold an egoistic and sometimes even misleading sense of assessment of his/her skill set. It could be a false appeal of their skills and intellect. One of the main talents of an investor is to understand how the market is functioning and which areas are facing fluctuations. Sometimes, a few good predictions can lead to analysts thinking highly of themselves and considering themselves better than the average investor. Overconfidence bias is seen not only in investors but also in other areas of life like sports, driving, and almost everything related to being an expert on a subject.

A survey shows that overconfidence bias is the most common among investors. This stems from people’s illusion that they control the outcome in the market or have greater knowledge than everybody else. Keynes also wrote in his General Theory, that the actual private object of the most skilled investment today is “to beat the gun”, outwit the crowd, and to pass the bad, or depreciating, half-crown to the other fellow.

James Montier, author of the book “The Little Book of Behavioural Investing: How Not to Be Your Own Worst Enemy”, conducted a survey of 300 professional fund managers, from all over the world and asked if they believed themselves to be better than the average investor. The results were astonishing, as 74% of the managers said “Yes” and the remaining 26% said that they consider themselves to be average. However, not every investor can be better than the average. That is mathematically impossible.

HOW DOES AN INVESTOR BECOME OVERCONFIDENT?

The overconfidence biases can be categorized into various categories. One of the categories is over ranking, in which as discussed earlier the person ranks his/her performance better than the average. The second one is the illusion of control. It makes the person believe that they are much more in control of the situation than they actually are. This increases the failure to assess risks. The third is the desirability effect. Sometimes it is referred to as “wishful thinking” as, through this people assume that the outcome will be desirable just because they want it to be desirable.

The feeling of overconfidence can be attributed to many factors. Firstly, there is a sense of self-appreciation, wherein we consider ourselves successful solely because of the skill set we possess. This might be true in many aspects of life, but in the investment and finance industry, luck plays a huge role as well. For example, making correct predictions about the market can lead to a boost in confidence. However, a persons’ skill set might not be held responsible if the predictions fail. It might be called a result of bad luck.

Secondly, investors choose to adopt a particular skill set that has worked for them in the past as their go-to method of calculating predictions and judging the market. This might work for them in a few concentrated times when the market has a similar external force structure. This builds confidence in them and causes the development of overconfidence bias. However, a good investor is the one who can study the marketplace in any given situation. Therefore, diversification of strategy is required.

From a very young age, we are told to be fearless and confident in ourselves, but in investing, the opposite is required. Overconfidence bias can lead to the neglect of risks involved in an investment. Diligent risk management is the key to being a successful investor. Being overconfident clouds our judgment and makes our decisions seem less risky than what they actually are. Ray Dalio, the founder of one of the world’s largest hedge funds- Bridgewater & Associates, told Forbes that he attributes his success to avoiding overconfidence bias. His statement stands as a testimony to the fact that even one of the best investors in the world does not consider himself above average.

HOW CAN ONE OVERCOME THE CONFIDENCE BIAS?

Diligence and taking a more objective look at the situation can decrease overconfidence. Attributing success to not only your skillset but also external factors and being aware of your luck in the situation can also help. Tracking the background of your predictions by asking questions such as “Are they coming from a place of overestimated skill set or are they backed by evidence of success?” is necessary. Furthermore, having the foresight of what the consequences of your investment decision will be like is helpful. Predicting failures or at least having a back-up plan prepared for adverse situations can also suppress the feeling of overconfidence. Lastly, seeking help and assistance, if required. Confiding in your peers and seeking advice or suggestions is a way of curbing the overconfidence bias.

Read other articles in this Finance series:

What is Mental Accounting Bias?

What is Hindsight Bias?

Get The Connectere directly in your E-mail inbox !

Enter your email address to subscribe to The Connectere and receive notifications of our new content on your E-Mail