This week we continue our examination of Emotional Biases by focusing on Overconfidence Bias.
According to Michael M. Pompian, author of Behavioral Finance and Wealth Management “In its most basic form, overconfidence can be summarized as unwarranted faith in one’s intuitive reasoning, judgments, and cognitive abilities.
In short, people think they are smarter and have better information than they actually do. For example, they may get a tip from a financial advisor or read something on the Internet, and then they’re ready to take action, such as making an investment decision, based on their perceived knowledge advantage.”
Pompian states that “Numerous studies have shown that investors are overconfident in their investing abilities. Specifically, the confidence intervals that investors assign to their investment predictions are too narrow. This type of overconfidence can be called prediction overconfidence. For example, when estimating the future value of a stock, overconfident investors will incorporate far too little leeway into the range of expected payoffs, predicting something between a 10 percent gain and decline, while history demonstrates much more drastic standard deviations. The implication of this behavior is that investors may underestimate the downside risks to their portfolios (being, naturally, unconcerned with “upside risks”!).
Investors are often also too certain of their judgments. We will refer to this type of overconfidence as certainty overconfidence. For example, having resolved that a company is a good investment, people often become blind to the prospect of a loss and then feel surprised or disappointed if the investment performs poorly. This behavior results in the tendency of investors to fall prey to a misguided quest to identify the “next hot stock.” Thus, people susceptible to certainty overconfidence often trade too much in their accounts and may hold portfolios that are not diversified enough.”
So how does Overconfidence Bias effect investors? Let’s see what Pompian has to say.
- Overconfident investors overestimate their ability to evaluate a company as a potential investment. As a result, they can become blind to any negative information that might normally indicate a warning sign that either a stock purchase should not take place or a stock that was already purchased should be sold.
- Overconfident investors can trade excessively as a result of believing that they possess special knowledge that others don’t have. Excessive trading behavior has proven to lead to poor returns over time.
- Because they either don’t know, don’t understand, or don’t heed historical investment performance statistics, overconfident investors can underestimate their downside risks. As a result, they can unexpectedly suffer poor portfolio performance.
- Overconfident investors hold underdiversified portfolios, thereby taking on more risk without a commensurate change in risk tolerance. Often, overconfident investors don’t even know that they are accepting more risk than they would normally tolerate.
Let us help you eliminate this bias. Professional advisors with disciplined systems of investing tailored specifically to your investment goals will allow you to overcome many of the obstacles inherent in our very nature. At DWAM, we can help.