The Overconfidence Bias

Fundamentals of Market Investing by Adam J. McKee

The overconfidence bias is the tendency of individuals to attribute investing success to their own talent and ability while blaming “bad luck” for his failure.  In other words, people are pretty narcissistic when it comes to evaluating their investing skills.  More formally stated, overconfidence is the tendency to place an irrationally exuberant level of confidence in one’s own abilities and assumptions.  Two different interpretations can give rise to such a definition.  The first is hubris or what is sometimes referred in the literature to as the “better-than-average effect.”  Think of this as an irrational shift in the perceived mean.

The second interpretation is a matter of miscalibration.  Miscalibration arises when the investor believes she understands what is going on better than she actually does.  In either case, the investor’s valuation of a security will be different from that of the market, and the overconfident investor will place more validity on his own valuation and less on the market’s valuation.

This generates more of a willingness to trade in the overconfident investor than we would see in a less confident investor.  There is some evidence that males are more prone to these types of errors than females.  Researchers of this perspective have observed that males trade more often than females.  The reason for the correlation cannot be started with any certainty, but there has been speculation.  One suggestion is that males are more overconfident than females.  (Another is that males are more prone to sensation seeking, and thus enjoy the thrill of trading more than females).

The research has also shown that this overconfidence has a significant impact on investor decision making.  This has led to theorization about a conservatism effect, meaning investors are reluctant to accept negative news about their portfolio holdings, and only sell reluctantly after some time has passed.  Perhaps the most insidious aspect of this phenomenon is that if we blame poor performance on bad luck rather than investing mistakes, we will not learn from those mistakes and our investing results will remain below our full potential.  It is interesting to note that several research teams have considered gender differences in the level of overconfidence found in investors, and all found that men have higher self-perceptions than women despite no significant difference in the returns that they could generate.

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Last Updated: 6/25/2018


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