Why you’re probably overconfident – and what you can do about it

Did January's market corrections distress you? Do you worry that wobbles – or worse – will return? If so, perhaps that’s because you were and remain overconfident. You’d hardly be alone: in research it conducted last year, Morningstar found that two-thirds of Americans, a similar proportion of its financial advisers and 80% of its Generation Z show signs of excessive confidence. That’s a big problem, since it also discovered that highly overconfident people are twice as likely to encounter financial difficulties such as insufficient savings, excessive debt and poor credit scores.

Whether explicitly or subliminally, we hear it all the time: in many aspects of life, confidence is a prerequisite of success. Seldom, however, do we recognise a critical caveat: more often than not, overconfidence eventually produces disappointment, error and failure. In many types of decisions, including investment, confidence is a two-edged sword. Without some self-confidence, you can’t succeed because your fear of failure paralyses you into inaction. But unwarranted assurance regarding matters about which we’re certain will, sooner or later, doom us to costly mistakes. “It ain’t what you don’t know that gets you into trouble,” Mark Twain wisely quipped. “It’s what you know for sure that just ain’t so.” Are you overconfident? How can you combat damaging hubris and cultivate healthy self-assurance? This article provides a test and some suggestions.

Confidence may augment health …

In order to appreciate both the importance of self-confidence and the danger of overconfidence, first consider a broader question: does an individual’s state of mind affect her physical and mental health? Holy Scripture is clear: “A joyous heart is good medicine,” says the Book of Proverbs (17:22) in the Complete Jewish Bible, “but low spirits sap one’s strength.” Psychologists and health researchers largely concur: contentment, gratitude and joy – which aren’t the same as happiness – can help to maintain and improve health and lengthen life. A good quantity, quality and variety of friendships and social activities help to combat and mitigate the depression which can also trigger, exacerbate and perhaps even cause some physical ailments. On several levels – individual and social, physical and mental – it’s far better to be joyful and grateful rather than disgruntled and resentful.

Consider now a more specific question: what say researchers about confidence? This catch-all term references an individual’s propensity to affirm statements such as “things are good right now” and “things are going to get even better.” A large literature addresses this question. From it emerge two tentative but intriguing conclusions:

1. optimists’ lifestyles seem to some extent to be healthier than pessimists’;
2. upbeat people are somewhat less susceptible than naysayers to some diseases.

Compared to pessimists, positive people tend to smoke less, exercise more, eat healthier foods (and avoid unwholesome ones) and imbibe moderate rather than excessive amounts of alcohol (including more wine and less spirits). As a rough estimate, an affirmative outlook may explain ca. 5-10% of the somewhat reduced likelihood that an individual will succumb to certain afflictions – including cardiovascular disease and stroke. Cheerfulness also seems to promote psychological well-being. “Put simply,” says a publication of the American Psychological Association, “optimists emerge from difficult circumstances with less distress than do pessimists … Optimists seem intent on facing problems head-on, taking active and constructive steps to solve their problems; pessimists are more likely to abandon their effort to attain their goals.”

It’s important to note these findings’ limitations. First, chronic melancholy may make some people physically sick; clearly, however, a patient’s positive outlook per se cannot cure his cancer. Second, this research has established correlations which are suggestive but inconclusive. In particular, no study can conduct a proper experiment; accordingly, none has specified strong causes and established compelling effects. Not only have empiricists been unable to establish causality: theorists haven’t ascertained its direction. Optimism, in other words, might make us rather healthier; just as plausibly, good health may beget somewhat more confidence.

A reasonable summary of this literature thus seems to be: a sunny outlook and rich social network may help to maintain and promote (and certainly won’t harm) your health.

… But overconfidence certainty retards investment success

An unrealistically upbeat attitude and assessment of your abilities and prospects, however, probably won’t make you wealthier. Quite the contrary: because it usually renders us less prudent, overconfidence typically makes us poorer.

The crux of the problem is that overconfident people systematically misperceive the past, present and future. They tend to remember and exaggerate positive experiences (such as profitable investments) but discount or forget bad ones (such as loss-making transactions). Indeed, the most overconfident can “re-remember” as successes what were clearly failures! Moreover, the overconfident extrapolate their exaggerated or imagined past “success” into the present and future.

Of course, almost everybody can recollect their major blunders. But even when these memories remain vivid, the overconfident remember them in a face-saving way. They’re likely to credit successes to their own skills, knowledge or intuition; but they also tend to attribute their failures to external causes or random factors – anything other than their own faults! Ellen Langer, a psychologist at Harvard University, summarised this mindset: “heads I win, tails it’s chance.”

The overconfident also attribute their successes to their own acumen rather than good fortune. After a certain amount of time passes and nothing bad happens, overconfident speculators conclude that it’s because they’re so smart – and not because they’re the lucky survivors of unfavourable odds.

Overconfident investors greatly overweight anecdotes, opinions and other current and subjective information, as well as “case rates,” and discount or ignore objective data – particularly long-term “base rates.” (If you don’t know the difference between a base rate and a case rate, you’re doing yourself no favours – and are likely overconfident. Investopedia’s article “Base Rate Fallacy” provides a good overview.) They thereby premise their choices upon irrelevant, invalid or unreliable information.

Overconfident investors disdain the estimation of risk, focus upon irrelevancies, ignore valid and reliable data and fail to consider crucial questions. They routinely make assertions such as “I expect that the price of X Ltd’s shares will increase y% during the next z months.” But they rarely ask questions like “of what class or classes is X Ltd a member? Over the long term, how do investments within these categories tend to fare? What are the risks and associated probabilities?” They don’t enquire because their overconfidence convinces them that their acumen, past and future returns are stronger than they really are (or likely will be).

Even if they know it, which most apparently don’t, it doesn’t matter to the overconfident that, for example, the average Initial Public Offering (IPO) is at best a mediocre and often a losing proposition: they believe that they can distinguish the small number of eventual winners from a large number of losers. According to The Australian (27 January), “more people lost on new stock market listings last year than made money … The losses during such a strong year for equity markets should be a wake-up call.” Quite the contrary: such results should surprise nobody because they’re the norm. According to NASDAQ (“What Happens to IPOs over the Long Run?” 15 April 2021), since 1981, three years after they floated almost two-thirds of IPOs significantly underperformed the overall market. It’s true that a few soar spectacularly; equally, however, many more sink abysmally.

Such misapprehensions lead the overconfident to transact too frequently, “invest” in areas that are much more risky than they realise, and “time” the market. The overconfident substitute their mistaken recollections and unrealistic expectations for base rates and plausible estimates of risk; and where such assessments aren’t available, they assert blind faith in their ability to steer a successful course through uncertainty.

Additional examples of this phenomenon are legion; one more will suffice. Have you ever bought shares of a business whose stock sells at a very high price relative to earnings? Why? To the extent that they recognise such actions’ risks, the overconfident focus upon the extreme right-hand (that is, profitable) side of the distribution (and greatly fatten its tail) and ignore its central tendency and left-hand (losing) side. In other words, they discount or ignore the “base rate” (that is, the key fact that over the long term these “investments” generate below-average results or outright losses) and exaggerate the “case rate” (their or others’ alleged ability to predict that this particular “hot” stock will beat the unattractive odds). 

Just as the bully is, deep down, insecure, bravado is the surface manifestation of underlying self-doubt. Overconfident market participants’ emotions are slaves of markets’ ups and downs: they buy when rising markets buoy their sprits, but sell when falling or crashing markets prompt them to take fright. As a result, they tend to buy high and sell low. Their “strategies” bring to mind the insight of boxing champion Mike Tyson: “everyone has a plan until they get punched in the mouth.”

“Experts” are also mostly overconfident

Overconfidence is rife in financial markets. It’s not just retail investors: financial advisers, central bankers, funds managers, journalists and senior executives also succumb to it. (In this context, it’s worth mentioning that men and women tend to make different kinds of financial mistakes. On average, women are less predisposed than men to overconfidence. Indeed, they often lack financial self-confidence. They thereby commit fewer investment errors of commission than men, but their reticence to invest is an error of omission.) Egged by bullish “experts,” people’s views about present and future economic conditions, overall markets’ and particular companies’ prospects, etc., when compared to subsequent reality, are unrealistically confident and optimistic.

If its consequences weren’t so costly, this situation would be comical: analysts, central bankers, journalists and strategists, who routinely and sometimes grossly overestimate their ability to prophesy, issue overly optimistic prognostications (based partly upon CEOs’ and economists’ overly sanguine biases) about companies and the economy as a whole. Moreover, investors who’re overconfident about their skills and excessively cheerful about the future gravitate towards companies run by arrogant (about their skills) and overly buoyant (about the future) executives! 

Experts are generally overconfident. Examining their track records, Philip Tetlock, the leader of a landmark study, concluded that those who predict most confidently are roughly correct no more than half of the time. As he tartly commented: “most experts would be far more accurate if they’d just toss a coin.”

Experts are also liable to “hindsight bias” – that is, they claim they knew more about what was going to happen than they actually knew at the time. That helps to maintain the self-delusion that they really are experts.

It’s therefore worth asking: does “predictive expertise” actually exist? It’s very doubtful. “Overconfident professionals sincerely believe they have expertise, act as experts and look like experts,” noted Daniel Kahneman. “They may be in the grip of an illusion.” As Warren Buffett has observed, a forecast tells us much about the forecaster’s state of mind today – but little about tomorrow’s state of reality (see also Experts can’t predict yet investors must plan: What, then, to do?).

A quick and simple way to diagnose overconfidence

For each of the following ten statements (see Scott Plous, “Overconfidence,” The Psychology of Judgment and Decision Making, McGraw-Hill, 1993), provide a low and high estimate such that you are 90% confident that the correct answer falls between them. For each statement, the tighter (wider) is your range, the more (less) confident is your response. The challenge is to navigate a course between overly narrow intervals (i.e., overconfidence) and excessively wide ones (under-confidence). If you successfully meet this challenge, your low-high range should exclude the correct answer 10% of the time – that is, just once. The larger is your number of misses, the greater is your overall overconfidence. (I scored two misses and barely avoided a third: despite my practicing and preaching, I’m still somewhat overconfident! How about you? Answers appear at the end of this article).

How You Can Diminish Overconfidence

The “heuristic of overconfidence,” as one study calls it, “biases our judgment.” Can overconfidence and its consequent bias – and poor investment decisions – be reduced? According to Plous, there are grounds for optimism:

What would be useful is a technique that decision makers could carry with them from judgment to judgment – something lightweight, durable, and easy to apply in a range of situations. And indeed, there does seem to be such a technique. The most effective way to improve calibration seems to be very simple: stop to consider reasons why your judgment might be wrong.

It seems trivially simple, but it seems to work: if you’re considering options such as whether to buy shares of X Ltd, sell Y Ltd, etc., for each option make a list of “pros” and “cons.” If possible, for each “pro” devise a corresponding “con.” After listing reasons for and against, it’s likely that you’ll be less overconfident and more accurate – presumably because you’ve devoted more balanced thought to the matter. It’s not the generation of reasons per se that improves calibration; rather, it’s the generation of opposing reasons: “when subjects listed reasons in support of their preferred answers, overconfidence was not reduced. Calibration improved only when subjects considered reasons why their preferred answers might be wrong.”

Perhaps I’m overly optimistic, but it seems to me that several groups of actions can help investors to identify and mitigate overconfidence:

Test Yourself

• Take a few online financial literacy tests. Are the results poorer than you expected? If so, then it’s likely that you’re overconfident.
• Relentlessly expand your investment knowledge. The more you learn, the more you might realise how little you know and how hard it is to generate decent results consistently. Both of these epiphanies work wonders for humility! 

Calculate Your Past Results

• What are your actual results over the long term (five years or more)? If you lack five years of investment experience, you’re likely overconfident. And if you haven’t calculated your results, you probably overestimate them and are overconfident about your prospective returns.
• Are your results lower than you expected? Hubris is a possible culprit.

Establish 90% Confidence Intervals

• Each time you consider a stock market investment, posit a low and high estimate of your expected return in five years’ time such that you’re 90% confident that the correct answer falls between the two.
• If your lower bound isn’t significantly less than zero, you’re kidding yourself and are woefully overconfident.

Discount Case Rates and Emphasise Base Rates

• For each prospective investment, insofar as possible discount (or better yet ignore) anecdotes, opinions and other uncorroborated and subjective information.
• Avoid overconfident people. The more prominent is the "expert," the more likely is his overconfidence.
• Instead, emphasise key objective data – particularly long-term “base rates.”

Ceaselessly Ask “What If I’m Wrong?”

• Every time you consider an investment, investigate contrarian alternatives – particularly regarding matters about which you’re most confident.
• By discussing your proposed actions, particularly with someone who’s dispassionate or sceptical, you can clarify why and how you reached your conclusion – and whether it’s sensible.

Conclusion

“No problem … in decision making,” says Scott Plous, “is more prevalent and more potentially catastrophic than overconfidence.” Yet a decision “is unlikely to be catastrophic unless decision makers are nearly certain that their judgments are correct.” Most “investors” were utterly sure about Dot Coms in the late-1990s – until they crashed and burnt in the early-2000s. Today, growing numbers entertain no doubt about cryptocurrencies, ESG (and “ethical funds”) and tech (particularly start-ups). If past is prelude, their fervour portends disillusion and worse.

Particularly if you’re a bloke, you’re probably overconfident. As a result, you’re not as good an investor as you think you are (indeed, you may be a speculator rather than an investor), and your expectations of future results are unrealistic. Self-confidence is a good – even an essential – thing, but too much is harmful.

Overconfidence leads investors to overestimate their prospective returns – and do risky things to get them. More than a decade ago, in “Why Many Investors Keep Fooling Themselves” (The Wall Street Journal, 16 January 2010), Jason Zweig concluded:

The faith in fancifully high returns isn’t just a harmless fairy tale. It leads many people to save too little, in hopes that the markets will bail them out. It leaves others to chase hot performance that cannot last. The end result of fairy-tale expectations, whether you invest for yourself or with the help of a financial adviser, will be a huge shortfall in wealth late in life, and more years working rather than putting your feet up in retirement.

As an investor and in other aspects of life, hubris is nemesis. When you become overconfident, you underestimate the likelihood that you’re wrong; when you’re convinced that you’re right, you fail to take seriously the consequences if you’re mistaken; and when you overestimate your knowledge and discount risk and uncertainty, you err. The greater is your overconfidence, the more frequent and costly your mistakes eventually become. 

In sharp contrast, investors worthy of the name are modest about their knowledge and ability; they’re also accurate about their past results and realistic about their prospects. Accordingly, they relentlessly test and amend their assumptions, ask questions and learn lessons; above all, they frankly admit they can’t reliably foresee – and are thus cautious about – the future. They ascertain base rates and risks, mind the downside and let the upside mind itself. Acting as if your personal and the general economic and financial glasses are less than half-full is an essential pillar of the mindset required to invest successfully over the long term (see also Successful investors are stoics).

The challenge of mitigating overconfidence isn’t so much accepting the venerable and reliable; it’s rejecting the novel and destructive. “The most difficult subjects can be explained to the most slow-witted man if he has not formed any idea of them already,” said Leo Tolstoy. “But the simplest thing cannot be made clear to the most intelligent man if he is firmly persuaded that he knows already …”

Answers to Plous’s test: (1) 39 years of age; (2) 4,187 miles; (3) 13 countries; (4) 39 books; (5) 2,160 miles; (6) 390,000 pounds; (7) 1756; (8) 645 days; (9) 5,959 miles; (10) 36,198 feet

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