Overconfidence Can be an Investor's Worst Enemy

Recently published in the Denver Business Journal, Volume 59, Number 14, September 28, 2007-October 4, 2007, (Denver Business Journal), by Richard M. Todd. A reprint of the article may be found by clicking this link (Reprint).

When a sample of students assessed their own driving skills, 82 percent judged themselves to be in the top 30 percent of the group.

Clearly, a large percentage of the students were overconfident about their driving abilities. The "Lake Wobegon" effect, named for Garrison Keillor's fictional town where "all the children are above average," is widespread.

For almost as long as psychologists have been studying human nature, they have found that people tend to overestimate their abilities, knowledge and skills. People overestimate their ability to do well on tasks, and these estimates increase with the importance of the task.

In financial matters, overconfidence can be costly. It causes people to overestimate their knowledge, underestimate risks and exaggerate their ability to control events. Overconfidence can lead to problems throughout the investment management process.

Why are investors overconfident?

There are many forces at work that explain the general tendency of overconfidence.

To some extent, it's also a result of the exceptional performance of the investment markets in the past 20 years. Investment professionals often state that "a rising tide lifts all boats" to indicate that even some poor investments go up when the broad market is rising. In other words, many investors give too much weight to the effect of their decisions and too little weight to the strong performance of the investment markets.

Another behavioral bias that increases investor overconfidence is the "illusion of knowledge." When people are given more information on which to base a forecast, the accuracy of the forecast doesn't increase proportionate to the increase in their confidence in the forecast. Additional information can lead to an illusion of knowledge and foster overconfidence.

Investors today have access to vast quantities of investment data, and as a result, are tempted to believe that so much data confers knowledge.

Another behavioral bias that increases investor overconfidence is the "illusion of control." People act as if their own personal involvement can influence the outcome of chance events. Because investors now can place investment orders with little or no intermediation of a live or full-service broker, they may feel that such direct involvement improves their chances of favorable outcomes.

Why does overconfidence persist?

An important question to ask about overconfidence is why it persists even in the face of experience.

In other words, why don't people temper their confidence levels based on their experiences?

People overestimate their own contributions to past positive outcomes. When people expect a certain outcome and that outcome occurs, they often overestimate the degree to which they helped make it happen.

On the other hand, when things happen that conflict with their expectations, they attribute those events to some other cause over which they had no control. In other words, they take credit for the successes, and blame the failures on chance.

Another reason overconfidence persists is that situations don't repeat themselves exactly, so investors are constantly faced with different issues. Unfortunately, life and investing aren't like the movie "Groundhog Day," in which Bill Murray relives the same day repeatedly.

In the context of financial decision-making, the investor may not even know that his overconfidence is resulting in poor investment performance. Considering the average investor's inability to accurately measure and evaluate investment performance, the investor may never realize the true cost of overconfidence.