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.
Types of Overconfidence Bias
Over the course of the research, two different types of overconfidence bias have been identified. The details of these biases have been written below:
- Certainty Overconfidence: Certainty overconfidence is the perceived ability of the investors to actually pick the next big stock with absolute certainty. These investors often believe that they have some kind of acumen, which allows them to pick the next winner at a very early stage.
Also, sometimes investors fall prey to the notion that the quantity of information received about an investment increases the quality of decision being made about it. The reality is that even if investors have more information about a prospective investment opportunity, it is unlikely to increase the efficiency of their decision making.
- Prediction Overconfidence: Prediction overconfidence is the behavior of investors wherein they tend to make very narrow predictions. This means that while predicting values, they assign a very narrow range. For instance, an investor may believe that the GDP of the USA in the next year will only change between negative 2% and positive 3%.
This may be a case of prediction overconfidence if data shows that GDP can vary between negative 10% and positive 10%! Prediction overconfidence bias makes investors falsely restrict the possible outcome to a very narrow range.
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.
Impact of Overconfidence Bias
Overconfidence bias may have a lot of negative impact on the investment decisions made by an investor. Some of the shortcomings have been listed below:
- Search for Multibagger Stocks: Investors with overconfidence bias often tend to believe that they can pick the next big stock. As a result, they often invest in a lot of risky penny stocks. They do some analysis or receive some information about a company which makes them believe that they are special. Therefore, they invest in risky stocks, and a lot of times, this ends up destroying the value of thier portfolio.
- Trading too Often: Investors with overconfidence bias are known to trade excessively. This is because they often believe that they are in possession of some special knowledge that other investors are not aware of.
However, it is a known fact that trading too much can be detrimental to investors well being. This is largely because of the transaction costs involved. However, it can also be detrimental because if an investor trades too often, they are more likely to end up picking some wrong stocks.
- Ignore Negative Information: Overconfidence bias hinders the ability of an investor to factually evaluate any investment. Their thoughts are always biased, and their decisions are made based on emotions instead of being based on fact.
This is the reason that investors often continue investing even after they may receive negative information about a company. Investors with overconfidence bias are far more likely to ignore negative information since they believe that they already know what’s best.
- Underestimate Risks: Investors with overconfidence bias are known to not pay attention to empirical stock data before they make any investments. This is the reason that they often underestimate the risks involved in their investments. Overconfident investors are known for holding portfolios that are less diversified. As a result, when the markets start to turn red, these investors often end up facing the biggest losses.
Overconfidence bias can be difficult to avoid. This is because whenever an investment decision is being made, investors are confident because of the research that they may have done. However, a lot of time, this confidence may be the result of a biased analysis. From an investor’s point of view, differentiating between confidence and overconfidence is almost impossible. This is what makes investing difficult, as well as interesting.