The Investor Behavior Series: Overconfidence
Introduction
In this week's article, we'll look at the behavior bias called “overconfidence” and how it affects investors.
In many aspects of life, people tend to overestimate their abilities. For example, most drivers believe they are better than average behind the wheel—and statistics prove them right! In a recent survey by AAA, over 70% of respondents said that they were above-average drivers.
Investors can mistakenly believe they are above-average performers, and make decisions based on these beliefs—which could have disastrous results.
The Investor Behavior Series is designed to help investors learn more about the biases and pitfalls that affect their investment decision-making. We'll examine some of the most common biases and how they can be overcome with knowledge and self-awareness.
Overconfidence and its Effect
Overconfidence is a common behavioral finance concept that describes an individual's belief in their own abilities or judgment, particularly when it extends beyond what the evidence suggests or implies. Overconfidence can have a number of negative effects on investors.
This overconfidence can also extend to an investor's faith or belief in a market prognosticator, company CEO, or a so-called investment expert that makes bold predictions about the market and its future performance. This can be detrimental to investors who fall prey to the charismatic prognosticator since they lose sight of other important factors that may affect investment performance.
Investors with an overconfidence bias are generally willing to invest aggressively without regard for the true underlying risk of their decision. There are a myriad of things that can happen when an investor is trapped with an overconfidence bias.
Overconfidence also makes it more likely that investors will hold onto losing investments for too long, reducing the amount of money and not having a clear investment method or strategy regarding their long-term goals and needs.
Overconfidence may also cause an investor to misjudge risks and make poor investment decisions based on limited information or analysis.
An overconfidence bias may increase transaction costs for the investor since they will engage in excessive trading of their portfolio in an attempt to beat the market.
Overconfidence bias and Illusory Superiority
People who suffer from this bias believe they are better than others at almost everything but have no real evidence to support this belief. People with illusory superiority are often unaware of their own biases and limitations, making them difficult to manage.
This overconfidence will cause many investors to attribute their successes as being due to internal factors but attribute failures as being external factors.
How Can You Overcome Overconfidence Bias?
Can an investor overcome the overconfidence bias? For one, a willingness to become better educated about the nature of markets and risk, as well as the many psychological biases innate to money and finance. By raising their cognitive awareness, an investor can delay the emotional reaction an investor can feel and experience when the market is tanking or racing to the top.
One of the key factors in becoming educated regarding this bias is to work with a financial planner who can serve as a trusted advisor and confidant. Rather than chasing market returns and looking for the next hot sector or market, they can help you develop a roadmap and strategy that captures market premiums through broad market diversification and targeting specific risk premiums.
Here are a few things you can do to overcome overconfidence:
Determine and get a thorough understanding of where market returns come from and how to capture specific return premiums by diversifying your portfolio.
Discover the “real returns” of your portfolio minus your trading and transaction costs.
Make sure your current portfolio and investment strategy can handle market volatility and downturns, or unexpected life (or lifestyle) changes.
Meet with a financial advisor who can develop a financial roadmap and strategy built on empirical factors regarding market returns and market risk premiums.
Can Overconfidence Ever Be a "Good Thing" for an Investor?
People who express overconfidence tend to be more optimistic about their potential for success than those who are less sure about themselves and the future. However, when this optimism reaches extremes it becomes problematic because it leads people to unwise decisions. The main reason why being overly confident has such negative consequences for your wealth is because it encourages you to take risks with your money that go against rational expectations of return relative risk profiles.
A Quick Note About FAANG Stocks and Overconfidence
Over the last few years, investors have been enticed and persuaded that the FAANG stocks were a sure thing with a never-ending stream of market-beating returns. What are FAANG stocks? They are a group of technology stocks: Facebook (META), Amazon, Apple, Netflix, and Google. As pundits and market forecasters touted FAANG stocks, many investors became "confident" and became narrowly invested in FAANG stocks. This past year FAANG stocks are down close to 40%.
Conclusion
In the end, it's important to note that overconfidence is a common human bias. We all have an innate desire to believe that we're better than others and more knowledgeable in our field of expertise. But as we've seen here, this can lead investors down a dangerous path full of poor decision-making that could result in significant losses for their portfolios. It's critical for investors to be aware of their own limitations when making investment decisions so they don't fall victim to overconfidence bias!
One of the best exercises you can do as an investor is to seek out the guidance and expertise of a trusted advisor. They can help you to determine if your current investment portfolio and strategy are prudent and appropriate. Many investors believe their current position is better than it actually is (i.e., they're overweighted in a stock(s) or sector). Further, many investors do not realize or understand how much risk they're taking on by investing in a particular asset class or strategy (i.e., underweighted).