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December 2014

Education

Behavioural finance: Overconfidence

December 2014

Of the psychological biases investors are prone to, overconfidence is perhaps the most damaging because our faith in our judgements usually exceeds their accuracy.

Surveys reveal that most people rate themselves “above average” when it comes to positive traits, such as driving ability, employment prospects or life expectancy. Such overconfidence is something investors must guard against. That’s not easy because overconfidence in yourself is fuelled by related psychological biases; namely optimism, the illusion of knowledge and the distortion of hindsight.

Most of us view the world as more benign than it is. We underestimate the likelihood of falling ill, for instance, yet overestimate the probability of good events happening to us, which explains bumper sales of lottery tickets.

Our optimistic nature is augmented by other factors that boost our confidence. The illusion of knowledge is our tendency to believe that the accuracy of our forecasts increases with more information. This is not a given; information is not the same as insight.

Today, investors are bombarded with information that encourages some to make frequent changes to their portfolios. However, studies suggest that these investors are guilty of overtrading, virtually guaranteeing mediocre returns after transaction costs. One explanation for overtrading is that investors feel motivated to master the environment. This is the illusion of control, the tendency to overestimate our ability to influence trajectories over which we have little control. 

On top of all this, hindsight distortions can feed confidence levels. By extrapolating recent experience into the future, we are often guilty of making confident predictions that are regularly proven wrong.

Overconfidence becomes especially problematic in bull markets – whether in shares or bonds – and during periods of sustained stability; when confidence takes hold that the prevailing conditions will persist. Yet our collective overconfidence in ourselves sows the seeds of our subsequent downfall. Economist Hyman Minsky is famous for observing that stability begets instability. His financial instability hypothesis suggests that people tend to take greater risks in periods of sustained stability. Minsky noted that capitalists extrapolate stable conditions far into the future, encouraging them to put in place ever-more-risky debt structures.

Overconfidence in our own ability is most conspicuous in share markets just before a slump, but it can equally apply to other assets whose valuations may not properly reflect the risks.

There is much to be said for considering the contrarian view and taking a range of outcomes into account. It’s a large part of why investors should have a diversified portfolio of risky and defensive assets. For diversification is a sleep-at-night solution to the problems stemming from overconfidence in ourselves and hindsight distortions.

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© 2017 FIL Responsible Entity (Australia) Limited ABN 33 148 059 009, AFSL No. 409340.
Fidelity, Fidelity International and the Fidelity International logo and F symbol are trademarks of FIL limited.

This document is issued by FIL Responsible Entity (Australia) Limited ABN 33 148 059 009, AFSL No. 409340 ("Fidelity Australia"). Fidelity Australia is a member of the FIL Limited group of companies commonly known as Fidelity International. Prior to making an investment decision retail investors should seek advice from their financial adviser. Please remember past performance is not a guide to the future. Investors should also obtain and consider the Product Disclosure Statements ("PDS") for the fund mentioned in this document. The PDS is available on www.fidelity.com.au or can be obtained by contacting Fidelity Australia on 1800 119 270. This document has been prepared without taking into account your objectives, financial situation or needs. You should consider such matters before acting on the information contained in this document. This document may include general commentary on market activity, industry or sector trends or other broad based economic or political conditions which should not be construed as investment advice. Information stated herein about specific securities is subject to change. Any reference to specific securities should not be construed as a recommendation to buy, sell or hold these securities. While the information contained in this document has been prepared with reasonable care no responsibility or liability is accepted for any errors or omissions or misstatements however caused. The document may not be reproduced or transmitted without prior written permission of Fidelity Australia. The issuer of Fidelity funds is FIL Responsible Entity (Australia) Limited ABN 33 148 059 009. References to ($) are in Australian dollars unless stated otherwise. © 2017 FIL Responsible Entity (Australia) Limited. Fidelity, Fidelity International, and the Fidelity International logo and F symbol are trademarks of FIL Limited.