Overconfidence: an Overview

We are generally overconfident; that is, we tend to overestimate how much we know.

People often overestimate their ability to predict future events, trust their knowledge more than they should, and believe they have a greater influence on random outcomes than they actually do (so called “illusion of control” bias (Langer 1975)).

In addition, the overconfidence phenomenon can be reinforced by cognitive biases such as the "self-attribution” bias, where individuals attribute their successes to their own abilities and blame failures on bad luck, and the "hindsight bias", where people believe they predicted an event after it has already occurred. (Barberis and Thaler, 2003).

Illustrating overconfidence in one’s own skills, and possibly optimism as well, Svenson (1981) finds that 82% of a sample of students placed themselves among the top 30% safest drivers.

Overconfidence has also been documented among experts and professionals, including those in the finance profession. For example, it is observed among corporate financial officers (Ben-David, Graham, and Harvey 2013) and among professional traders and investment bankers (Glaser, Langer, and Weber 2013).


Overconfidence in a financial context

A financial trade requires that two parties agree to disagree in the sense that at a given price one party believes it is a good idea to sell the asset while the other party believes it is a good idea to buy it.

While disagreement on the value of an asset may be a driving factor for trade, other factors such as liquidity needs or portfolio diversification may also play a role. It is well-documented that individuals in the economy often hold divergent views on the value of securities, with many individuals believing that he or she is correct.

In overconfidence-based models, investors who are overconfident form judgments about the value of a security by putting too much weight on their own views and insufficient weight on the views of other investors (as reflected in the security’s price). As a result, overconfident investors expect high profits from trading on their opinions and overinvest.

The excessive trading of individual investors can be called the active investing puzzle.


Active investing puzzle

Individual investors trade individual stocks actively, and on average lose money by doing so. The more actively investors trade, the more they typically lose (Odean 1999).

Barber and Odean (2000) discovered that a subset of households in a sample of 78,000 clients of a large discount brokerage firm from 1991 to 1996 had significantly higher trading activity. They also found that the turnover, gross returns, and net returns varied among the different groups of clients based on their trading activity, as illustrated in Figure 1.

The gray bars represent the average monthly turnover for accounts in each quintile, with the fifth quintile having an average turnover of over 20% per month. The white bars indicate gross returns, revealing little variation across quintiles.

However, the black bars demonstrate a significant difference in net returns. Investors with high turnover pay large fees, resulting in lower net returns due to their high volume of trades.

A range of evidence from a wide variety of sources suggests that overconfidence provides a natural explanation for the active investing puzzle because it causes investors to trade more aggressively even in the face of transactions costs or adverse expected payoffs (Odean 1998).

The prototype of the overconfident

In the popular imagination, young people are reckless and overconfident, whereas senior citizens are cautious and circumspect.

Moreover, psychologists found that in areas such as finance men are more overconfident than women.
Thus, our prototype should be a young man with a strong fascination for the financial world.

While Barber and Odean (2001) found that the average turnover for accounts opened by men is about 1.5 times higher than accounts opened by women (and as a result men pay 0.94 percent per year in higher transaction costs), Bhandari and Deaves (2006) found that (supposed) precision in judgment increases with age.

In addition, it seems that the prototype of the overconfident is a highly-educated male who is nearing retirement, who has received investment advice, and who has experience investing for himself.

Conclusion

Overconfidence is a commonly observed phenomenon in human behavior, product of cognitive biases and social influences.
As other biases and heuristics, knowing and being aware of its existence it’s the only weapon that we have, in order to reduce its effects and consequences.

So, next time you're feeling extra confident, remember to take a step back and consider the possibility that you may be overestimating your abilities.