Behavioural finance: The problems caused by overconfidence

Posted by Stephen Sutherland on Thu, Jul 19, 2012 @ 02:24 PM

Behavioural finance and overconfidenceIn our final post on behavioural finance, we'll look at the problems overconfidence can cause for investors.

Overconfidence is a decision-making bias that humans are prone too. Psychological studies show that, although people differ in their degrees of overconfidence, almost everyone displays it to some degree. For example, much more than half the population claim to be above average drivers, or have an above average sense of humour. There is also a tendency for individuals to place too much confidence in their own investment decisions, beliefs and opinions.

Think of confidence as a continuum: Lack of confidence is paralyzing, self-confidence is good, but overconfidence is deadly. Overconfidence can cause real problems for investors who mistake luck for skill. For instance when something turns out well after a decision we’ve made, we claim the credit. However, when something goes badly, we tend to see this as just bad luck or misfortune. Many investors fall into the trap of believing they can pick winning investments. As a result, they sometimes put too much of their wealth into one single investment, such as a company stock, which can be very risky. Research shows that picking winning investments is incredibly hard to do, even for professional investors. 

Overtrading and underperformance

Investors with too much confidence in their skills often buy and sell too often, which can have a negative effect on their returns. Research shows that those who buy and sell often are at a disadvantage compared to those who take a long-term view and trade less frequently. In a 2006 study entitled 'Behaving Badly', researcher James Montier found that 74 per cent of the 300 professional fund managers surveyed believed that they had delivered above-average job performance.

Of the remaining 26 per cent surveyed, the majority viewed themselves as average. Incredibly, almost 100 per cent of the survey group believed that their job performance was average or better. Clearly, only 50 per cent of the sample can be above average, suggesting the irrationally high level of overconfidence these fund managers exhibited. As you can imagine, overconfidence (i.e. overestimating or exaggerating one's ability to successfully perform a particular task) is not a trait that applies only to fund managers. Keep in mind that there's a fine line between confidence and overconfidence. Confidence implies realistically trusting in one's abilities, while overconfidence usually implies an overly optimistic assessment of one's knowledge or control over a situation.

Avoiding Overconfidence

To avoid overconfidence in your own investing, document and review your investment record. It's easy to remember your one stock that gained 50 per cent in a single day, but records may reveal that most of your investments are under water for the year. Successful investors seek to find a balance between rashness and timidity. Understanding the psychology that causes us to act overconfidently will help you avoid it.  

Before we really understand something, we may either lack confidence or express overconfidence. A common type of overconfidence stems from inexperience. For instance, more than 70 per cent of naive investors wrongly assume they are enjoying above-average returns. Also bear in mind that professional fund managers, who have access to the best investment industry reports and computational models in the business, can still struggle at achieving market-beating returns. The best fund managers know that each investment day presents a new set of challenges and that investment techniques constantly need refining. Just about every overconfident investor is only a trade away from a very humbling wake-up call.

In conclusion

During this series of blog posts focusing on the topic of ‘behavioural finance’ we’ve discovered that psychological research has documented a range of biases that can affect decision making about money and investing. These biases sit deep within our psyche and as fundamental parts of human nature they affect all types of investors, both professional and private. Understanding them can help you to learn to work around them.

Modern portfolio theory is built on the assumption of ‘the economic investor’ – a rational being who wants the maximum return for a given level of risk. However, the ‘economic investor’ is also presumed to be a dispassionate individual who is unaffected by emotions such as greed, anxiety, regret, hope and fear. The purpose of this blog series was to demonstrate that this rational investor simply does not exist. Everyone sees the world from a perspective which is uniquely theirs, and investing is no different.

People have individual goals, requirements, desires, fears and hopes for their wealth. We all have different habits, different people we trust for advice, and different beliefs about the right decision on any occasion. But we all exhibit very similar psychological biases in our financial decision making, which can lead to poor portfolio choices and subsequent investment performance. Understanding your financial personality is vitally important. It can help you understand why you make the decisions you make, how you are likely to react to the uncertainty inherent in investing, and how you can temper the irrational elements of investment decisions while still satisfying your individual preferences.

In this blog series we highlighted some of the cognitive ‘traps’ in investing that most people are susceptible to. Thinking about these in the light of your own financial personality report will help you avoid them. Indeed, understanding your own financial personality and common investing biases will improve the investment experience for you from day one onwards.

Please note past performance should not be used as a guide to future performance, which is not guaranteed. Investing in Funds should be considered a long-term investment. The value of the investment can go down as well as up and there is no guarantee that you will get back the amount you originally invested.


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Topics: Investment strategy, Behavioural Investing, Achieving your investment goals