The damaging effects of overconfidence
In a world of uncertainty in which our brains are often subconsciously working against us, it’s a good practice to regularly challenge our investment views. “Am I being overconfident in my beliefs about the future?” “Am I being overly optimistic about the prospects of certain assets based on recent experience?” “Is my portfolio diversified enough given a range of (good and bad) scenarios?”
Of all the psychological biases investors are prone to, overconfidence is perhaps the most pervasive and damaging. Simply put, this is where confidence in our own judgements is greater than it actually is.
Surveys reveal that the vast majority of people rate themselves “above average” among their peers when it comes to positive traits, such as driving ability, employment prospects, or life expectancy. In one of the most famous surveys, an overwhelming majority of 93% of American drivers rated themselves as better than average!
Overconfidence is fuelled by a number of other related psychological biases:
- Optimism is a perfectly sensible coping strategy for life but can be problematic when investing. We routinely underestimate the likelihood of falling ill for instance, yet, overestimate the probability of good events happening to us, which goes a long way to explaining lottery ticket sales.
- The illusion of knowledge is the tendency for people to believe that the accuracy of their forecasts necessarily increases with more information. This however is not necessarily the case given information is not the same as insight.
- The illusion of control, is the tendency to overestimate our ability to influence events over which we have little control. Today, investors are bombarded daily with financial information, and every twist and turn in stock markets is discussed at length. This information encourages some investors to make frequent changes to their portfolios. However, studies suggest that these investors are in fact overtrading and virtually guaranteeing themselves mediocre returns after transaction costs.2 One explanation for overtrading is that investors feel motivated to master the environment -The illusion of control.
- Hindsight bias can feed confidence levels further. By extrapolating recent experience into the future, (often based on limited data), investors are often guilty of making confident predictions that are regularly shown to be flawed.
Overconfidence becomes particularly problematic in bull markets and in periods of sustained stability.
During these periods, the “good times” are widely expected to continue forever, and overconfidence becomes prevalent among allocators of investment capital.
Indeed, our collective bias towards overconfidence in good times seems to sow the seed of our subsequent downfall. Economist, Hyman Minsky famously observed that “stability begets instability”. His ‘Financial Instability hypothesis’ suggests that people tend to take greater and greater risks in periods of sustained stability. Minsky observed that capitalists extrapolate stable financial conditions into the future, encouraging them to put in place ever-more risky debt structures, which ultimately undermine stability itself.
In challenging times, overconfidence can work the other way, combining with hindsight bias to result in over-pessimism. In the same way that we are guilty of becoming overconfident in the good times, during the bad times we can become much too confident things will stay gloomy. Again we are guilty of letting hindsight and information dominate our thinking.
There is much to be said for considering the contrarian view and taking account of a range of possible outcomes. Certainly, all investors should discipline themselves to challenge established or prevailing views and consider whether they are properly diversified across asset classes and regions.
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