If you were asked to give a range of weights for a fully loaded 747 jumbo jet, such that you were 90% confident that the actual weight fell into your range, what would you say? What if you were similarly asked to give a 90% confidence range for the length of the Nile River – how would you respond?
If you’re like most people, you would provide ranges that are far too narrow and do not come close to containing the correct answers. Why? Because you, like nearly everyone else, likely suffer from overconfidence bias.
What does it mean to be “overconfident?” In technical terms, it means that a person’s subjective confidence in his or her own judgment, ability, or belief is greater than the objective accuracy of that judgment, ability, or belief.
In lay terms, it simply means that we think we’re better than we really are, and it turns out that nearly everyone behaves this way.
People tend to be overconfident in their abilities in many arenas, from karaoke singing to starting a business to parallel parking. This phenomenon has been highlighted time and again in various studies. For example, in one particular study, a group of college students were asked to rate their driving abilities as either below average, average, or above average. Statistically, self-ratings should be distributed evenly between these three categories.
However, as much as 82% of the students rated their abilities as above average, which is clearly impossible. In a similar study, a group of entrepreneurs were asked to rate their businesses’ chances of success. 81% believed that their businesses had at least a 70% chance of success, while 33% believed that their chances of success were 100%!
In reality, the data suggest that only 25% of those businesses would exist five years later.
Investing provides plenty of fertile ground for overconfidence to take root, and, consequently, this bias is very commonly observed in investors’ behavior in the capital markets. There are two sides to every trade (which makes a market!), and each side believes his or her information and/or analysis to be superior to that of the counterparty.
By definition, this must be the case or the trade would never happen.
But both parties cannot possibly be correct! Confidence in one’s investment analysis and conclusions is what ultimately leads one to make a trade, which, in and of itself, is completely rational. However, overconfidence can lead to making too many trades, which most certainly can be detrimental to a long-term investing strategy.
Research has shown that overconfidence leads to increased portfolio turnover rate, which is strongly correlated with sub-par investment returns. Put simply, investors who are overconfident in their abilities to pick investments tend to trade more often and earn lower returns than investors who do not suffer from this bias. Investors who adhere to a thoughtful buy-and-hold strategy tend to outperform investors who trade more often.
Overconfidence presents serious risks for investors. In its milder form, it can lead to chronic underperformance, and in some cases it may lay the groundwork for more serious investing mistakes. Given these risks, investors should be wary of the effects of overconfidence bias and work hard to overcome them.
One of the most effective ways to combat the overconfidence bias is to seek out analysis that conflicts with one’s own investment theories. Our natural tendency is to do the opposite, looking instead for information or analysis that agrees with our pre-determined conclusions. However, by actively seeking to understand how one’s conclusions might be wrong, an investor’s confidence can be tempered, resulting in a more measured approach to investing decisions.
As an investor, you should be skeptical of everything, especially your own conclusions, because most likely you’re just not as good as you think you are.