17
Emotional Bias #2: Overconfidence Bias

Too many people overvalue what they are not and undervalue what they are.

Malcolm S. Forbes

Bias Description

Bias Name: Overconfidence

Bias Type: Emotional

General Description

In its most basic form, overconfidence can be summarized as unwarranted faith in one's intuitive reasoning, judgments, and cognitive abilities. Although the concept of overconfidence derives from psychological experiments and surveys in which subjects overestimate both their own predictive abilities and the precision of the information they've been given (essentially cognitive weaknesses), these faulty cognitions lead to emotionally charged behavior, such as excessive risk-taking, and therefore overconfidence is classified as an emotional rather than cognitive bias. In short, people think they are smarter than they actually are and have better information than they actually do. For example, they may get a tip from a financial advisor or read something on the Internet, and then they're ready to take action, such as making an investment decision, based on their perceived knowledge advantage.

Examples of Overconfidence Bias

Prediction Overconfidence

Roger Clarke and Meir Statman demonstrated a classic example of prediction overconfidence when they surveyed investors on the following question: “In 1896, the Dow Jones Average, which is a price index that does not include dividend reinvestment, was at 40. In 1998, it crossed 9,000. If dividends had been reinvested, what do you think the value of the DJIA would be in 1998? In addition to that guess, also predict a high and low range so that you feel 90 percent confident that your answer is between your high and low guesses.”1 In the survey, few responses reasonably approximated the potential 1998 value of the Dow, and no one estimated a correct confidence interval. (If you are curious, the 1998 value of the Dow Jones Industrial Average [DJIA], under the conditions postulated in the survey, would have been 652,230!)

A classic example of investor prediction overconfidence is the case of the former executive or family legacy stockholder of a publicly traded company such as Johnson & Johnson, ExxonMobil, or DuPont. These investors often refuse to diversify their holdings because they claim “insider knowledge” of, or emotional attachment to, the company. They cannot contextualize these stalwart stocks as risky investments. However, dozens of once-iconic names in U.S. business have declined or vanished.

Certainty Overconfidence

People display certainty overconfidence in everyday life situations, and that overconfidence carries over into the investment arena. People tend to have too much confidence in the accuracy of their own judgments. As people find out more about a situation, the accuracy of their judgments is not likely to increase, but their confidence does increase, as they fallaciously equate the quantity of information with its quality. In a pertinent study, Baruch Fischhoff, Paul Slovic, and Sarah Lichtenstein gave subjects a general knowledge test and then asked them how sure they were of their answer. Subjects reported being 100 percent sure when they were actually only 70 percent to 80 percent correct.2 A classic example of certainty overconfidence occurred during the technology boom of the late 1990s. Many investors simply loaded up on technology stocks, holding highly concentrated positions, only to see these gains vanish during the meltdown.

Implications for Investors

Both prediction and certainty overconfidence can lead to making investment mistakes. Box 17.1 lists four behaviors, resulting from overconfidence bias, that can cause harm to an investor's portfolio. Advice on overcoming these behaviors follows the diagnostic test later in the chapter.

Am I Subject to Overconfidence Bias?

This is a diagnostic test for both prediction overconfidence and certainty overconfidence. After analyzing the test results in the next section, we will offer advice on how to overcome the detrimental effects of overconfidence.

Prediction Overconfidence Bias Test

Question 1: Give high and low estimates for the average weight of an adult male sperm whale (the largest of the toothed whales) in tons. Choose numbers far enough apart to be 90 percent certain that the true answer lies somewhere in between.

Question 2: Give high and low estimates for the distance to the moon in miles. Choose numbers far enough apart to be 90 percent certain that the true answer lies somewhere in between.

Question 3: How easy do you think it was to predict the collapse of the housing and credit bubbles of 2008–2009?

  1. Easy
  2. Somewhat easy
  3. Somewhat difficult
  4. Difficult

Question 4: From 1926 through 2010, the compound annual return for equities was approximately 9 percent. In any given year, what returns do you expect on your equity investments to produce?

  1. Below 9 percent
  2. About 9 percent
  3. Above 9 percent
  4. Well above 9 percent

Certainty Overconfidence Bias Test

Question 5: How much control do you believe you have in picking investments that will outperform the market?

  1. Absolutely no control
  2. Little if any control
  3. Some control
  4. A fair amount of control

Question 6: Relative to other drivers on the road, how good a driver are you?

  1. Below average
  2. Average
  3. Above average
  4. Well above average

Question 7: Suppose you are asked to read this statement: “Capetown is the capital of South Africa.” Do you agree or disagree?

Now, how confident are you that you are correct?

  1. 100 percent
  2. 80 percent
  3. 60 percent
  4. 40 percent
  5. 20 percent

Question 8: How would you characterize your personal level of investment sophistication?

  1. Unsophisticated
  2. Somewhat sophisticated
  3. Sophisticated
  4. Very sophisticated

Prediction Overconfidence Bias Test Results Analysis

Question 1: In actuality, the average weight of a male sperm whale is approximately 40 tons. Respondents specifying too restrictive a weight interval (say, “10 to 20 tons”) are likely susceptible to prediction overconfidence. A more inclusive response (say, “20 to 100 tons”) is less symptomatic of prediction overconfidence.

Question 2: The actual distance to the moon is 240,000 miles. Again, respondents estimating too narrow a range (say, “100,000 to 200,000 miles”) are likely to be susceptible to prediction overconfidence. Respondents naming wider ranges (say, “200,000 to 500,000 miles”) may not be susceptible to prediction overconfidence.

Question 3: If the respondent recalled that predicting the rupture of the credit and housing bubbles in 2008–2009 seemed easy, then this is likely to indicate prediction overconfidence. Respondents describing the collapse as less predictable are probably less susceptible to prediction overconfidence.

Question 4: Respondents expecting to significantly outperform the long-term market average are likely to be susceptible to prediction overconfidence. Respondents forecasting returns at or below the market average are probably less subject to prediction overconfidence.

Certainty Overconfidence Bias Test Results Analysis

Question 5: Respondents professing greater degrees of control over their investments are likely to be susceptible to certainty overconfidence. Responses claiming little or no control are less symptomatic of certainty overconfidence.

Question 6: The belief that one is an above-average driver correlates positively with certainty overconfidence susceptibility. Respondents describing themselves as average or below-average drivers are less likely to exhibit certainty overconfidence.

Question 7: If the respondent agreed with the statement and reported a high degree of confidence in the response, then susceptibility to certainty overconfidence is likely. If the respondent disagreed with the statement, and did so with 50 to 100 percent confidence, then susceptibility to certainty overconfidence is less likely. If respondents agree but with low degrees of confidence, then they are unlikely to be susceptible to certainty overconfidence. Confidence in one's knowledge can be assessed, in general, with questions of the following kind:

Two decades of research into this topic have demonstrated that in all cases wherein subjects have reported 100 percent certainty when answering a question like the Australia one, the relative frequency of correct answers has been about 80 percent. Where subjects have reported, on average, that they feel 90 percent certain of their answers, the relative frequency of correct answers has averaged 75 percent. Subjects reporting 80 percent confidence in their answers have been correct about 65 percent of the time, and so on.

Question 8: Respondents describing themselves sophisticated or highly sophisticated investors are likelier than others to exhibit certainty overconfidence. If the respondent chose “somewhat sophisticated” or “unsophisticated,” susceptibility is less likely.

Investment Advice

Overconfidence is one of the most detrimental biases that an investor can exhibit. This is because underestimating downside risk, trading too frequently and/or trading in pursuit of the “next hot stock,” and holding an under-diversified portfolio all pose serious “hazards to your wealth” (to borrow from Barber and Odean's phrasing). Prediction and certainty overconfidence have been discussed and diagnosed separately, but the advice presented here deals with overconfidence in an across-the-board, undifferentiated manner. Investors susceptible to either brand of overconfidence should be mindful of all four of the detrimental behaviors identified in Box 17.1. None of these tendencies, of course, is unavoidable, but each occurs with high relative frequency in overconfident investors.

This advice is organized according to the specific behavior it addresses. All four behaviors are “wealth hazards” resulting frequently from overconfidence.

  1. An unfounded belief in one's own ability to identify companies as potential investments. Many overconfident investors claim above-average aptitudes for selecting stocks, but little evidence supports this belief. The Odean study showed that, after trading costs (but before taxes), the average investor underperformed the market by approximately 2 percent per year.3 Many overconfident investors also believe they can pick mutual funds that will deliver superior future performance, yet many tend to trade in and out of mutual funds at the worst possible times because they chase unrealistic expectations. The facts speak for themselves: from 1984 through 1995, the average stock mutual fund posted a yearly return of 12.3 percent, whereas the average investor in a stock mutual fund earned 6.3 percent.4
  2. Excessive trading. In Odean and Barber's landmark study, “Boys Will Be Boys,” the average subject's annual portfolio turnover was 80 percent (slightly less than the 84 percent averaged by mutual funds).5 The least active quintile of participants, with an average annual turnover of 1 percent, earned 17.5 percent annual returns, outperforming the 16.9 percent garnered by the Standard & Poor's index during this period. The most active 20 percent of investors, however, averaged a monthly turnover of over 9 percent, and yet realized pretax returns of only 10 percent annually. The authors of the study do indeed seem justified in labeling trading as hazardous.

    When an investor's account shows too much trading activity, the best advice is to ask the investor to keep track of each and every investment trade and then to calculate returns. This exercise will demonstrate the detrimental effects of excessive trading. Since overconfidence is a cognitive bias, updated information can often help investors to understand the error of their ways.

  3. Underestimating downside risks. Overconfident investors, especially those who are prone to prediction overconfidence, tend to underestimate downside risks. They are so confident in their predictions that they do not fully consider the likelihood of incurring losses in their portfolios. For an investor who exhibits this behavior, the best course of action is twofold. First, review trading or other investment holdings for potentially poor performance and use this evidence to illustrate the hazards of overconfidence. Second, point to academic and practitioner studies that show how volatile the markets are. The investor often will get the picture at this point, acquiring more cautious respect for the vagaries of the markets.
  4. Portfolio under-diversification. As in the case of the retired executive who can't relinquish a former company's stock, many overconfident investors retain under-diversified portfolios because they do not believe that the securities they traditionally favored will ever perform poorly. The reminder that numerous, once-great companies have fallen is, oftentimes, not enough of a reality check. In this situation, the advisor can recommend various hedging strategies, such as costless collars, puts, and so on. Another useful question at this point is: “If you didn't own any XYZ stock today, would you buy as much as you own today?” When the answer is “No,” room for maneuvering emerges. Tax considerations, such as low-cost basis, sometimes factor in; but certain strategies can be employed to manage this cost.

A Final Word on Overconfidence

One general implication of overconfidence bias in any form is that overconfident investors may not be well prepared for the future. For example, most parents of children who are high school-aged or younger claim to adhere to some kind of long-term financial plan and thereby express confidence regarding their long-term financial well-being. However, a vast majority of households do not actually save adequately for educational expenses, and an even smaller percentage actually possess any “real” financial plan that addresses such basics as investment, budgeting, insurance, savings, and wills. This is an ominous sign, and these families are likely to feel unhappy and discouraged when they do not meet their financial goals. Overconfidence can breed this type of behavior and invite this type of outcome. Investors need to guard against it, and financial advisors need to be in tune with the problem. Recognizing and curtailing overconfidence is a key step in establishing the basics of a real financial plan.

Notes

  1. 1   Roger G. Clarke and Meir Statman, “The DJIA Crossed 652,230,” Journal of Portfolio Management 26, no. 2 (Winter 2000): 89–92.
  2. 2   Sarah Lichtenstein, Baruch Fischhoff, and L. D. Phillips, “Calibration of Probabilities: The State of the Art to 1980,” in David Kahneman, Paul Slovic, and Amos Tversky, eds., Judgment under Uncertainty: Heuristics and Biases (New York: Cambridge University Press, 1982), 306–334.
  3. 3   Terrance Odean, “Do Investors Trade Too Much?” American Economic Review 89(5) (December 1999): 1279–1298.
  4. 4   Brad M. Barber and Terrance Odean, “Boys Will Be Boys: Gender, Overconfidence, and Common Stock Investment,” Quarterly Journal of Economics 116(1) (February 2001): 261–292.
  5. 5   Terrance Odean, “Do Investors Trade Too Much?” American Economic Review 89(5) (December 1999): 1279–1298.
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