How Overconfidence Can Cost Us Dearly
We have high opinions of ourselves
We have a tendency to elevate our self-belief. Several studies have shown that overconfidence consistently leads us to an explicit disparity: the difference between what we think we know and what we really know. After researching its impacts for two decades the behavioural economist Richard Thaler noted in 1995, “Perhaps the most robust finding in the psychology of judgment and choice is that people are overconfident.”
A famous analysis by the research scientist Ola Svenson in 1981 confirmed this assertion. In a report entitled, “Are we all less risky and more skilful than our fellow drivers?” it found that 93% of American drivers rate themselves as better than the median.
Nobody is immune from its effects. In a 2005 study¹ the finance professors Ulrike Malmendier and Geoffrey Tate argued that personal characteristics of CEOs in large corporations lead to distortions in corporate investment policies. They stated that overconfident CEOs systematically overestimate the return on their investment projects.
Numerous tragedies and chaotic events – ranging from the Titanic sinking to the Chernobyl disaster to the global financial crisis – can all be attributed to excessive levels of confidence (and the related optimism bias). Participants, and so-called ‘experts’ in particular, rarely believe such outcomes can occur.
Nobel prize-winning psychologist Daniel Kahneman called overconfidence “the most significant of the cognitive biases”. He stated in a Guardian newspaper interview in 2015 that if he had a magic wand, overconfidence would be the human bias he would most like to eliminate.
It is only natural, therefore, to assume that the effects of this powerful behavioural trait also have severe consequences for our money.
How overconfidence can affect our finances
Overconfident investors can be impervious to their shortcomings. This can lead them to trade excessively because they believe they have the skills to time the market, which is usually a mistake. A costly mistake.
In the 30 years to the end of 2016, a study by Dalbar Associates found that the average investor in US stocks received around 4% per annum compared to the market return of over 10%. This shortfall can be partly attributed to investors choosing the wrong points to trade in and out of the market.
In this respect, the overconfidence bias also reveals a gender bias. Research for The Quarterly Journal of Economics² discovered that men trade 45% more than women, with trading reducing men's net returns by 2.65% a year, and lowering women’s by 1.72% a year.
While the percentage difference seems minor, even a 1% effect on our portfolios each year makes a significant impact over time.
Other results of overconfidence include being poorly diversified by placing too much conviction in a limited number of stocks, and being more prone to the bias of loss aversion: our certitude can make us hold on to a failing investment for too long because we are convinced it will recover.
Lessening the effects of overconfidence
Ideally, investors should chart a course between imprudence and timidity. Yet simply recognising that we can be prone to overconfidence is one of the best ways to deal with its effects. We should also not pay too much attention to others who display excessive confidence or conviction.
Finally, we may minimise the consequences of overconfidence and other biases by assigning a company to invest on our behalf. For Netwealth’s part, we focus on constructing efficient, diversified portfolios, understanding that the trading costs incurred by emotive responses to market events can significantly reduce investment performance.
Please remember that when investing your capital is at risk.
1 CEO Overconfidence and Corporate Investment (Malmendier, Tate)
2 “Boys will be boys: gender, overconfidence, and common stock investment” Barber, Odean 1998.