What is Overconfidence Bias?
Overconfidence bias is a tendency to hold a false and misleading assessment of our skills, intellect, or talent. In short, it’s an egotistical belief that we’re better than we actually are. It can be a dangerous bias and is very prolific in behavioral finance and capital markets. This guide will unpack the overconfidence bias in more detail. Learn more in CFI’s Behavioral Finance Course.
Overconfidence Bias in Finance and Investing
Understanding where the markets are going and so on is one of the most important skills in finance and investing. In this industry, most market analysts consider themselves to be above average in their analytical skills. However, it is obviously a statistical impossibility for most analysts to be above the average analyst.
James Montier conducted a survey of 300 professional fund managers, asking if they believe themselves above average in their ability. Some 74% of fund managers responded in the affirmative. 74% believed that they were above average at investing. And of the remaining 26%, most thought they were average. In short, virtually no one thought they were below average. Again, these figures represent a statistical impossibility.
Learn more about Montier’s findings in his 16-page study.
It’s fascinating to see how common it is to hear fund managers state something like, “I know everyone thinks they’re above average, but I really am.”
The danger of an overconfidence bias is that it makes one prone to making mistakes in investing. Overconfidence tends to make us less than appropriately cautious in our investment decisions. Many of these mistakes stem from an illusion of knowledge and/or an illusion of control.
Let’s explore illusions of knowledge and control, and think about how we can avoid the overconfidence bias.
Fear of Being Wrong is Helpful in Investing
While confidence is often considered a strength in many situations, in investing, it tends to be more frequently be a weakness. Careful risk management is critical to successful investing. But being mistakenly overconfident in our investment decisions interferes with our ability to practice good risk management. The overconfidence bias often leads us to view our investment decisions as less risky than they actually are.
Ray Dalio, founder of the world’s largest hedge fund, Bridgewater & Associates, has commented many times that being overconfident can lead to disastrous results. In an interview with Forbes, he attributed a significant amount of his success to avoiding any overconfidence bias. Dalio states that he makes it a point to stay keenly aware of the possibility of his assessments being incorrect. “I knew that no matter how confident I was in making any single bet, that I could still be wrong.” With that mindset, he always strives to consider worst-case scenarios and take appropriate steps to minimize his risk of loss.
Dalio’s statement regarding his analytical ability is a powerful one coming from someone who, by all accounts, is one of the people who might be well-justified in thinking themselves above (way above) average at investing.
Types of Overconfidence
The easiest way to get a thorough grasp of overconfidence bias is to look at examples of how bias plays out in the real world. Below is a list of the most common types of biases.
#1 Over Ranking
Over ranking is when someone rates their own personal performance as higher than it actually is. The reality is that most people think of themselves as better than average. In business and investing, this can cause major problems because it typically leads to taking on too much risk.
#2 Illusion of Control
The illusion of control bias occurs when people think they have control over a situation when in fact they do not. On average, people believe they have more control than they really do. This, again, can be very dangerous in business or investing, as it leads us to think situations are less risky than they actually are. Failure to accurately assess risk leads to failure to adequately manage risk.
#3 Timing Optimism
Timing optimism is another aspect of overconfidence psychology. An example of this is where people overestimate how quickly they can do work and underestimate how long it takes them to get things done. Especially for complicated tasks, business people constantly underestimate how long a project will take to complete. Likewise, investors frequently underestimate how long it may take for an investment to pay off.
#4 Desirability Effect
The desirability effect is when people overestimate the odds of something happening simply because the outcome is desirable. This is sometimes referred to as “wishful thinking”, and is a type of overconfidence bias. We make the mistake of believing that an outcome is more probable just because that’s the outcome we want.
Thank you for reading this CFI guide to understanding how the overconfidence bias can impact investors. Learn more in CFI’s Behavioral Finance Course.
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