Overconfidence Bias in investing

Investing with Overconfidence

 

Overconfidence Bias in Investing

Overconfidence bias looms large when investing. Among the most common ways to shoot yourself in the foot, overconfidence is prevalent and pervasive.

What is overconfidence bias, and what are some examples of overconfidence bias while investing?

 

What is Overconfidence Bias?

Most consider themselves above-average drivers.

Overconfidence is the source of our enhanced driving abilities; it is the human tendency to overprize our talents and intelligence.

As a bias, of course, none of us will admit overconfidence. But, like other biases, it is easy to see in others and difficult to see in ourselves.

Overconfidence can be broken down into different types:

Types of Overconfidence

  1. Overrating yourself: this is our above-average-driver
  2. Assumption of prediction abilities: you predict something that you have no control over
  3. Unrealistic optimism: the belief that everything’s coming out roses.

The American Psychological Association defines overconfidence as

a cognitive bias characterized by an overestimation of one’s actual ability to perform a task successfully, by a belief that one’s performance is better than that of others, or by excessive certainty in the accuracy of one’s beliefs.

It is good to be self-confident but balance a truthful self-concept.

Let’s now look at some examples of overconfidence bias in action.

 

Three Examples of Overconfidence Bias in Investing

Here are three examples of overconfidence bias in investing.

Overconfidence Example: Why Women are Better Investors

Women, on average, are better investors than the alternative. This is an example of an overconfidence bias while investing.

It is relatively straightforward: women are better at investing than men (you look at geometric returns and the sex of the account owner). Why do women make better investors than men?

The data are not a slam dunk that there is female alpha. Some studies show superior returns from female account owners (up to 1% annually), while others do not.

Regardless, there is a consensus that women are better at investing. If that is the case, why?

Here is a list of what makes women better investors:

  • More risk-averse
  • Better self-control
  • Trade less frequently
  • Less overconfident
  • Better educated
  • Follow advice
  • Better savors
  • Less prone to selling during volatility

Let’s dig into a few of those further.

Women are More Risk-Averse

Is this such a bad thing? Women engage in less risk-seeking behavior than men. This is a “just-so” story from the evolutionary perspective but can still be seen in many facets of modern-day life.

Avoiding excessive risk is a good thing!

Less Overconfidence

Women are less overconfident than men. While this is related to being more risk-averse, there are important considerations.

First, the implication (which is true) is that men are overconfident. As far as behavioral biases go, one of the most devastating is overconfidence.

The stock market is full of overconfidence. Whenever you make a trade, you are betting that a stock will do something, but the person on the opposite side of the transaction is betting that the stock will do the exact opposite! So every time you do something in investing, you are betting that you are more intelligent than the other guy.

If women trade less often, they know it is because they are not more intelligent than the other guy! Same thing with an aversion to risk, better self-control, and not selling during a panic.

Women can be downright self-deprecating when it comes to investing. But is that expressed self-confidence necessary? No! What you say about your confidence level is not essential; it is what you do about it.

Don’t ask a woman if she is confident about her competence; watch how she behaves when making investing decisions. From a behavioral investing standpoint, women get invested, stay invested, and keep an appropriate level of risk—all big wins.

Dunning-Kruger

Just as impostor syndrome is more common in women, the Dunning-Kruger effect is more common in men.

Remember, while everyone thinks they are an above-average driver, most also think they are a below-average juggler.

Self-reported competence has everything to do with how difficult the task is. The easier the task, the more people think they are above average. The more complex the task, the more people believe they are underaverage.

For men with the Dunning-Kruger effect, one hopes they realize that being good at something becomes more complex as they progress.

More often than not, women have imposter syndrome rather than Dunning-Kruger. With Imposter syndrome—everyone would have difficulty with the task, but women tend to underplace themselves and think they cannot do it as well as others. Any capable person struggles with a difficult task.

So, while men are overconfident with easy tasks, women tend to underplace themselves, especially with complex tasks (like investing).

Overconfidence is pernicious and an error of commission. On the other hand, Underplacement is more minor and an error of omission.

If you are optimistic that you will be a good investor (vs. pessimistic), you don’t perform any better! Competence is essential in determining the outcome, regardless of whether you are over- or under-confident.

Women are underconfident compared to men but are more competent investors. The female alpha is alive and well; all investors can learn from successful female investors.

 

Overconfidence Example: Why Doctors Shouldn’t Invest in the Healthcare Sector

Why Doctors Shouldn’t Invest in the Healthcare Sector is the second example of overconfidence bias. Because you work in healthcare, does that mean you know more about investing in healthcare than the average investor?

We all have biases. A common bias for doctors is that the brighter you are, believe it or not, the more susceptible you are to these biases and not know it.

I see many physicians who are overweight in the healthcare sector or buy individual stocks in the industry. Because we know a product or use a drug, we feel like we have more information than the market.

Understand that the information we think we are privy to is already priced. We are not more intelligent than the market. We do not have a unique insight into the healthcare industry because we work in it.

Rather than overweighting the healthcare sector, doctors should actually underweight it. When you lose your job, it will most likely be due to a downturn in the sector, and you won’t lose twice (your income and your investments). The whole sector will go in and out with the tides. The contagion will take down your industry and the entire sector. Don’t let that happen at the worst time when you have also lost your job due to the same contagion.

Don’t fall prey to overconfidence bias! Underweight the healthcare sector if your paycheck also depends on the sector. And please don’t pick individual equities because you feel you have inside knowledge. You don’t.

 

Overconfidence Example: Generalized Financial Advice

Our final example of the overconfidence bias comes from reliance on others. I have said that you cannot depend too much on an advisor. So, here is the retirement mistake: generalized retirement advice.

Generalized retirement advice can be too hot, too cold, or just right, like the porridge in the Goldilocks fable.

You get one shot at retirement. Is that generalized retirement advice the retirement mistake of a lifetime? How do you know if it is just right for you?

Let’s look at overconfidence in the generalized financial advice realm.

 

Overconfidence in Retirement Advice

At a bare minimum, retirement advice must account for fundedness and risk tolerance.

behavioral investing

 

Look at the figure above to understand overconfidence in generalized advice. On the left is income level (or total asset amount/fundedness for retirement), and on the top is risk level (or risk tolerance).

Regarding retirement income, when you listen to generalized retirement advice, it may not apply because of your level of fundedness or risk.

As for risk, a “100% equity asset allocation” might be good advice for a youngster willing to take on short-term market risk. Conversely, it is horrible advice if someone commits the cardinal sin of investing and sells low, even once in their lifetime. Only when you bake in the appropriate level of risk is the advice correct. Too much or too little risk and the recommendation is wrong.

As for the level of fundedness, advice is not the same for those who have undersaved as for those who have oversaved. If you have undersaved, the best thing to do is to plan for social security. On the other hand, if you have oversaved, the retirement risks are different for you.

The advisor who gives generalized advice suffers from overconfidence bias, as no one person finds generalized advice useful. Yet we all offer advice!

So, what happens when the well-funded listens to generalized retirement advice?

How can generalized retirement advice provide you with the answers? Unfortunately, it can’t, and listening to all the talking heads (including those on the internet with blogs) is a retirement mistake born from overconfidence bias.

Advice is intended for a person with a specific income and risk level. You are not that person. Remember particular facts and circumstances. Don’t take advice from advice-givers.

It is lousy advice unless it is “Just Right” for your fundedness and risk level.

Choose your advice carefully. Facts and circumstances make all the difference with overconfidence bias.

 

Summary: Overconfident Investing

These examples of overconfidence bias in action show how prevalent and pervasive the issue is. Unfortunately, we all suffer from overconfidence bias, especially if we think we are intelligent.

As a result, there are typical problems seen as a result of overconfidence bias:

  1. Thinking you are not overconfident
  2. Overestimating what we can do
  3. Underestimating how long something will take
  4. Having a baseline of skill that diminishes continuous learning

We all remain susceptible to overconfidence bias in behavioral finance. Unfortunately, despite knowing we are overconfident, it is a complex problem to fix.

 

Posted in Financial Independence.

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