What is Overconfidence Bias?
Overconfidence bias leads to the false assumption that someone is better than others, due to their own false sense of skill, talent, or self-belief. It can be a dangerous bias and is very prolific in behavioral finance and capital markets. This guide will unpack the concept 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 professionals think they are above average when obviously that is impossible.
James Montier conducted a survey of 300 professional fund managers asked how many of them believe that they are above average in their jobs. There were similar results for what we’ve seen with other examples, such as with driving abilities. Some 74% of fund managers responded in the affirmative, so 74% believed that they were above average at investing. And of the remaining 26%, most thought they were average. In fact, virtually no one thought they were below average, which, again, is impossible.
Learn more about Montier’s finding in his 16-page study.
What is fascinating is often, fund managers would get quotes like this “I know everyone else thinks they’re above average, but I really am.”
The real danger, of course, is overconfidence can actually lead to many mistakes in investing, and it tends to stem from an illusion of knowledge and an illusion of control.
So let’s explore what illusions of knowledge and control actually are and think about how do we put this bias, this overconfidence bias, in check.
Fear of Being Wrong is Helpful in Investing
While confidence is often considered a strength in many situations, in investing, it may actually be the total opposite.
Ray Dalio, the founder of the world’s largest hedge fund, called Bridgewater & Associates, has publicly commented many times on his lesson that being overconfident can lead to disastrous results.
In an interview with Forbes, he said that “I knew that no matter how confident I was in making anyone bet I could still be wrong.”
That’s a powerful public statement from someone who would, by all accounts, be one of the most justified people in thinking he’s above average (way above) at investing.
Types of Overconfidence
The easiest way to get a thorough grasp of overconfidence bias is to look at examples of how it plays out in the real world. Below is a list of the most common types of biases.
#1 Over Ranking
Over ranking is what when someone rates their own personal performance as higher than it actually is. The driving examples described above are cases of over ranking. The reality is that most people think of themselves as better than average. In business and investing, this can cause major problems, as CEOs and fund managers believe they are better than everyone else, which can cause them to take 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 do. This can also be very dangerous in business as it leads executives to think situations are less risky than they actually may be.
#3 Timing Optimism
Timing optimism is another part of overconfidence psychology where people overestimate how quickly they can do work and 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.
#4 Desirability Effect
The desirability effect is when people overestimate the odds of something happening because the outcome is desirable or preferable to the alternatives. This is sometimes referred to as wishful thinking, where people want something to happen so badly they think it’s much more likely than it actually is.
Thank you for reading this guide to understanding how the overconfidence bias can impact investors. Learn more in CFI’s Behavioral Finance Course.
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