What is the Overconfidence Bias
Alex Chong Wei Kang, Research Analyst Intern
Reviewed By Charlie Yuan Ting Jing, CFA, CQF
Introduction
The overconfidence bias is a well-documented phenomenon in the field of psychology. It occurs when people display an unrealistically positive view of their own abilities, judgments, and prospects. This bias can lead to a number of problems, such as poor decision-making, unrealistic expectations, inflated egos, and led to wrong investment decisions. Overconfident investors are more likely to take risks that they are unable to bear, and this can lead to financial losses.
In this article, we’ll take a look at the overconfidence bias in investment psychology and explore what are the causes and how it can impact investors. We’ll also offer some tips on overcoming this bias when making investment decisions.
Definition of Overconfidence Bias
The overconfidence bias is a cognitive bias that refers to our tendency to be more confident in our abilities than is warranted. This bias can lead us to take on too much risk, make poor or wrong decisions, and be too arrogant till unable to note our own mistakes. The overconfidence bias is often seen in stock investors, who may make risky decisions based on their overconfidence in their ability to pick winning stocks and believe they can time the market.
Despite the potential downside, overconfidence bias can also have some positive effects. People who are overconfident tend to have higher levels of self-esteem. Additionally, overconfidence can lead to increased motivation and risk-taking, which can lead to greater rewards.
Why does Overconfidence Bias Exist
The overconfidence bias is a cognitive bias that causes people to overestimate their abilities and underestimate the abilities of others. There are a number of reasons why the overconfidence bias exists. For one, people tend to be more confident when they have less information and are less likely to second-guess themselves. Additionally, humans are hardwired to seek out patterns and see meaning in things, even when there is none. This can lead us to mistakenly see patterns where there are none and to overestimate our own abilities.
How Overconfidence can lead to Bad Investment Decisions
Many people believe that they are better than average investors, but this overconfidence can often lead to bad investment decisions. When people are overconfident, they tend to take more risks and make impulsive decisions without doing the proper research. This can have disastrous consequences, especially in the volatile world of investing. As human beings, we have to admit that overconfidence did affect our judgment and it will block us from seeing the radical truths.
Examples of Overconfidence Bias
“Do you think your driving skill is better and safer than at least 50% of the people?”
This is the question asked by research scientist Ola Svenson to the American people in 1981. You might expect around 50% or 60% of the people will say yes, but unfortunately, you are falling into the trap of overconfidence too.
The answer is startling 93% of Americans believe their driving skills are better and safer on the road. It's difficult to imagine that 9 out of 10 Americans who drive on the road are being overconfident about their actual driving skills. This experiment partially signalled that people are always overconfident about what they are doing, and usually it's not aligned with the facts.
Investment Examples of Overconfidence Bias
No one is perfect, even the legendary investor Ray Dalio experienced an overconfidence bias which cost him a huge lesson but it successfully changed him and brought him to his current success through his Principles. We can witness his overconfidence and arrogance in this snippet.
In the early 1980s, the young Ray Dalio from Bridgewater predicted a depression would soon hit the US as they saw the fallout from the silver crash. He was highly confident about it as he extremely believes his exhausting research and even worse, he spoke about it publicly to Congress. But the reality of turnout proves he is exceptionally wrong, the US experienced an economic boom after his awful speech.
Ray Dalio: “I was dead wrong….Being so wrong and especially so publicly wrong, was incredibly humbling and cost me just about everything I had built at Bridgewater.”
The consequences are devastating, at one point, he couldn't afford to pay the people who worked with him and he had to let them go. Until Bridgewater was now down to just one employee: him. Losing people he cared so much about and very nearly lost his dream of working for himself.
Ways to Overcome Overconfidence Bias
There are a few ways to avoid this trap. First, investors should be aware of their own biases and second, they should have a clear investment plan that takes into account their risk tolerance. By being mindful of these things, investors can avoid the pitfalls of overconfidence and make better decisions for their portfolios. Always keep in mind that there is always risk involved and no one can know how things will go in the stock market. By being humble and doing your own research for any investment decisions, you can avoid making costly mistakes that can set you back financially.
The Bottom Line
Despite the negative effects of the overconfidence bias, it's important to remember that it's a natural phenomenon. We all have a tendency to be overconfident at times, and it's not always a bad thing. In fact, a healthy dose of confidence can be helpful in many situations. The key is to be aware of the bias and to try to offset it with humility and critical thinking. Some of the ways to mitigate its effects are by increasing self-awareness, developing a healthy sense of scepticism, and seeking out diverse perspectives. We can all reduce the impact of the overconfidence bias in our lives.
Author
This article is written by Alex Chong Wei Kang, Research Analyst Intern
Alex Chong Wei Kang is a fresh graduate majoring in International Business at University Malaysia Sabah (UMS). Alex onboarded TED Optimus Sdn. Bhd. for 3 months and responsible to research Malaysian listed companies and article writing. He is also a junior research executive in Financial Literacy for Youths: Malaysia, a student-run organization aimed to improve financial literacy amongst youths in Malaysia. He was an in-house author of TED Optimus.
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