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Overconfidence Bias

  March 9,2020

Do you have overconfidence bias? Find it out

We all are familiar with the word ‘overconfidence’. While confidence is good and very much required, overconfidence tends to blur our rational decision-making capacity. There is a thin line between confidence and overconfidence and it makes all the difference in the outcome. 

Overconfidence is nothing but overestimation of one’s capabilities. In the world of investing, overconfidence acts as an impediment and it is called overconfidence bias. As investors with overconfidence bias are overconfident in their investment decisions, they tend to take hasty decisions ignoring the dangers. As a result, it does them more harm than good.

Let us explain overconfidence through the help of an example.

An investor who is new to the world of mutual funds starts investing in a mutual fund that has delivered the best performance in the last one year. The fund continues to outperform for other few months. The investor continues to add money in the fund. Because of the recent growth, the investor becomes overconfident and begins to overestimate his investment skills. However, he hasn’t done any research regarding the fund. The fund is a sectoral fund (sectoral fund invests in a particular sector) and the fund performance starts to stagnant. As he is overconfident, he continues to invest.

This is a typical case of overconfidence as the investor took the decision without consulting a financial advisor and believed that he knew better.

What causes Overconfidence Bias?

Behavioural biases are not exclusive to other biases. Other biases such as self-serving bias and illusory superiority are some of the reasons behind overconfidence bias. In the self-serving bias, investors attribute success to their expertise and losses to bad luck. Any information about the stock market which is in lines with the investor’s forecast will increase the confidence of the investor. As time goes, correct predictions make the investors super confident in his investment decisions. This is one way that gives rise to overconfidence bias.

Illusory superioritycauses investors to believe that they posse higher investment skills than they already have. While confidence is good, overconfidence, especially in the matters of investing, can be dangerous. This overconfidence bias can inversely impact the portfolio.

As a result, investors remember the recent gains but forget about the losses that they had made.

What are the effects of overconfidence bias?

As overconfident investors overestimate their investment prowess, they tend to take more risky investment decisions than they can digest. They overestimate the rewards and underestimate the risks.

Also, these investors tend to be more active traders or may jump from one mutual fund to another fund in a short span of time. This constant shuffling and trading may increase the investment costs that may eat away the returns fetched by the investment options.

Overconfident investors find it hard to seek investment help from professionals like financial advisors. As a result, they remain stuck in the vicious cycle of buying and selling according to their confidence level. This does not let investors make substantial gains or create wealth. 

How to Overcome Overconfidence Bias?

Knowing about overconfidence bias is not enough, overcoming it is very important.

Markets are ever-changing and it is nearly impossible to predict it. While seasoned fund managers and investment professionals may get it right a few times, but that does not indicate that they will continue to get it right every single time. Even after access to world-class reports and outlook by the best investment brains, seasoned traders may also get it wrong. Hence, it is important to be realistic while taking investment decisions.

The second way to overcome overconfidence bias to analyse the performance of the portfolio at regular intervals such as every quarter. This will force investors to look at the losses and the bad investment decisions that he had taken in the past. It is going to shift his perspective, throw a new light, and make the investor aware that no one is perfect. This will help the investor to focus on the financial goals, his risk tolerance level and investment horizon.

Thirdly, investors can also take professional help. While we may like to believe that we have above-average knowledge about investing, it may not be the truth. Financial advisors will help to put things into perspective so that investors do not make blunders in their financial journey.

Overcoming behavioural biases may not be easy. Do not give up hope and keep working towards making rational investment decisions