Humans are astonishing creatures that are often astonishingly wrong about many things without even realizing it. Overconfidence is the human bias that causes investors a lot of losses, and we’re going to talk about it. Simply put: overconfidence the unfounded confidence one has in the abilities of themselves or that of others.
Thinking Fast and Slow
According to Daniel Kahneman, author of one of the best psychology books called ‘Thinking Fast and Slow’ and Nobel prize winner, overconfidence is particularly strong among investors. More than most other groups, investors tend to exaggerate their own skill and deny the role of chance. They overestimate their own knowledge, underestimate the risks involved
Before you think ‘not me’..
Chances are that you read this and thought: ‘as if overconfidence affects me.. I’m a pretty down to earth man/woman’. However, Daniel Kahneman showed a situation that was awkwardly recognisable.
Mr Kahneman conducted an experiment. In this experiemt he asked a large group of participants about their competence as automobile drivers in relation to the average driver. The results showed that 80 – 90% of the respondents invariably say that they are more skillful and safer drivers than others in the class. Almost all respondents consider themselves to be above average. That’s statistically impossible.
Another way to describe overconfidence is illusory superiority. It’s one’s belief that they are better than average compared to other people in a given area of life. Be it looks, social skills or driving ability.
The phenomenon is very common and appears in all kinds of people. So common, in fact, that it comes up every time psychologists carry out experiments with it.
The Dunning-Kruger Effect
The Dunning-Kruger effect is what can be observed as a result of multiple people suffering from illusory superiority.
This graph shows that people with the least amount of experience tend to have extremely disproportionate levels of confidence in their ability. It is only when people become true experts in a certain field that they regain some of that confidence. The period in between is where people become painfully aware of how little they know and as a result their confidence drops.
Many investors are convinced that they can beat the market because of overconfidence. It leads to them speculating more than they should and trading way too often. Knowing your human limits and acknowledging them as being REAL is how you begin overcoming overconfidence.
Acknowledging your weaknesses is a strength, whereas failing to do so makes for another weakness.
The Market is Rarely Beat
Studies have found that the more individual investors traded, the worse they did. It even turned out that male investors traded much more than women, with correspondingly poorer results. This is exactly the reason why I praise a ‘buy and hold’ strategy so much.
The Effects of Overconfidence
According to researchers, overconfidence in the ability to predict future growth leads to overvaluation. So called ‘growth stocks’ tend to be massively overvalued as a result of overconfidence in the ability to predict future growth. Additionally, exciting new technologies also affect the assessment abilities of investors. It leads them to expect nothing but success and project higher growth rates for the companies involved.
Therefore, the expectations regarding the earnings of these companies are extremely overestimated, with investors having more confidence than is justified. This leads to investors investing more and more money into stocks that they are overconfident about (The dotcom bubble of 2000 is a great example of this overconfidence).
VIDEO OF KAHNEMAN AT BIG THINK
Eventually, the financial laws of gravity will leave these investors with an empty wallet and a damaged ego.