The risk of overconfidence bias when managing your portfolio
- Confidence is often regarded as a great quality to have, however, when this transforms into overconfidence bias, it can lead to mistakes.
- Overconfidence is a form of bias whereby an individual is outrightly confident of their decisions and overestimate or exaggerates their ability to perform a task.
- Investors with overconfidence bias could potentially override models and data simply because they are convinced they know better.
- There are several factors that could condition overconfidence bias including self-attribution bias and the illusion of control, the illusion of knowledge and over ranking performance amongst others.
- Some of the consequences of overconfidence bias are that an investor can underestimate the risks and overestimate the expected returns, they may trade excessively or hold poorly diversified portfolios.
- If you are having difficulties curbing your overconfident tendencies, you should get help from a professional. Together with your financial advisor you can create a financial plan that will outline both your short and long-term investment goals so that you can make the most of your portfolio without placing you at risk. Get in touch with one of CC’s financial advisors.
Confidence is often considered a great quality, regarded a strength in many situations. Without it investors may second-guess their investment choices and harm their portfolio returns. However, developing what is known as overconfidence bias – being mistakenly overconfident in our investment decisions – can interfere with our ability to practice good risk management. What’s more, it can make an investor more prone to making mistakes, while it can create a vicious cycle in which investors buy when they feel confident, sell when they get worried, miss the recovery and jump right back in when the markets feel safe again.
Have a look at why overconfidence can be a risk when managing your portfolio, what signs you should watch out for and why you should check your biases at the door before making any investment decision.
What is overconfidence bias?
Overconfidence bias is a bias in which people demonstrate unwarranted faith in their own intuitive reasoning, judgements and/or cognitive abilities. This overconfidence may be the result of overestimating knowledge, abilities and access to information. More specifically, self-attribution bias is a bias in which people take credit for successes and assign responsibility for failures. In other words, success is attributed to the individual’s skill, while failures are attributed to external factors.
What‘s more, people generally do a poor job of estimating probabilities, yet they believe they do it well because they think they are smarter and more informed than they actually are. This view is sometimes referred to as the illusion of knowledge bias. Overconfidence may be intensified when combined with other forms of bias like self-attribution.
Although subtle and difficult to distinguish, overconfidence can have negative effects when it comes to investment outcomes, while the real danger is that investors with overconfidence bias tend to override models and data because they are convinced they know better. This perspective coupled with ignoring the early signs of potential damage may cause more harm than good.
What can cause overconfidence bias?
The tendency to hold a false and misleading assessment of our skills, intellect or talent at trading can lead investors to make several bad decisions. Caused by alarmingly high levels of optimism, overconfidence is often fueled by other psychosocial biases such as self-serving or self-attribution bias mentioned earlier on. Any of these biases could potentially drive an investor to become unable to see the potential dangers of their actions, ending up making rash decisions that could simply cost a fortune.
Other biases include:
The illusion of control: this consists of the belief that we have total control of a situation or we can influence an event when in actual fact we cannot. In investing this could lead investors to believe that a particular situation is less risky. The illusion of control is often seen in investors who overtrade and those who make frequent changes to their portfolios. One reason why this could be so is that they feel they have mastered the environment, however, this move simply guarantees mediocre returns after transaction costs.
Over ranking performance: this can occur if we believe that we are better than average and rank our personal performance higher than we should. This may also lead to taking on too much risk.
The illusion of knowledge: linked to the over ranking performance bias, the illusion of knowledge is when we believe that our forecasts are precise and can lead to good results. Yet, if these forecasts are based on hindsight bias which can feed confidence levels even further as opposed to accurate and concrete information, this could lead investors to make confident predictions that are eventually proven to be flawed.
Extrapolation effect: when investors tend to remember their gains but forget their losses, this could lead them to extrapolate their own performance and be overconfident of their skills. Yet, mistakes can also serve as good lessons.
Timing optimism: investors often underestimate how long it may take for an investment to pay off, which again can cause issues. In fact, overconfidence has proven to be particularly problematic during bull markets and periods of sustained stability, since these periods are expected to carry on forever.
Desirability effect: this can occur when investors overestimate the odds of something happening simply because the outcome is desirable. Often referred to as wishful thinking, believing that an outcome is more probable just because we would like it to take place, may not truthfully reflect reality.
What are the consequences of overconfidence bias?
As a result of overconfidence bias, investors tend to be more active traders than required. They underestimate risks and overestimate expected returns and this vicious cycle can make them more prone to mistakes, while it can also mitigate their gains, mainly due to the fact that they overestimate their abilities to value companies, predict movements and growth and they move in and out of positions frequently. The end result is a poorly diversified portfolio with lower returns.
Overcoming overconfidence bias
Investors should review their trading records, identify the winners and losers and calculate portfolio performance over the past two years. Bearing in mind that investors with an unfounded belief in their own ability to identify good investments may only give importance to their wins and underestimate the number and results of their losses, a conscious review process will force them to acknowledge these.
When investors engage in too much trading, they should keep track of every investment trade and calculate returns since doing so can demonstrate the detrimental effects of excessive trading. Overconfidence is also a cognitive fault so having a complete and holistic picture can often help investors understand better the error of their ways.
In addition, investors must be objective when making and evaluating investment decisions. The old Wall Street saying – ‘Don’t confuse brains with a bull market’ – that warns about self-attribution seems fitting in this case. This is why it is important to take into consideration the reasoning behind any investment decision, whether positive or negative and to bei as objective about their own behaviour as possible. Ultimately, self-attribution and overconfidence biases can drive you to repeat the same mistakes.
An investor’s psychology plays an important role when it comes to the decision-making process, yet these are often influenced by our intuitions and feelings. Similarly, investment decisions also rely on a combination of factors including habits, emotions, reason and social interaction.
Behavioural biases, particularly overconfidence can drive an investor to take certain steps and suffer the consequences such as financial loss. Recognising the signs of overconfidence and knowing when and how to apply the brakes can prevent you from making faulty and bias-clad judgements. If doing so has proven to be difficult, then sound professional advice is invaluable and it can be just the right input you need. From pinpointing gaps in your financial plan to helping you identify your financial goals and determining how your investments may help you achieve these, an advisor can help you unlock your investment potential. Get in touch with one of our financial advisors today.