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.