Being Overconfident can destroy wealth

Jan 09, 2023

Overconfident investors feel they can ‘beat the market’. Hence, they ignore the risk involved and invest far more than their less confident counterparts. They tend to buy overpriced assets, invest in risker portfolios, and have lower returns. SAGNEET KAUR, associate director of behavioural research, writes on quick mental techniques that could alert investors on what can go wrong.

In April 1995, McArthur Wheeler boldly robbed two banks in Pittsburgh without using a disguise. To prevent himself from getting caught, he smeared his face with lemon juice believing that surveillance cameras at the bank would not be able to catch him. His logic was simple, that lemon juice would make his face blur.  It is used to write invisible letters that become visible only when held close to a heat source; he thought the same thing would work on his face too. He got arrested on the same day he conducted the robbery.

We can laugh at this, and indeed prominent social psychologists, Justin Kruger and David Dunning, have used this example in their journal, Unskilled and Unaware of it: How Difficulties in Recognizing one's own Incompetence led to Inflated Self-Assessments, to humorously illustrate overconfidence in our lives and its pernicious effects. However, it behoves us all to understand overconfidence, what it can do to investing, and how to overcome it.

Understanding the overconfidence bias and how common it is.

In general, overconfidence bias comes from misleading beliefs about our skills and talents. Under its shadow, we often overestimate our knowledge, underestimate potential risks, and exaggerate our abilities to control events or make forecasts about the future. We believe we are better than we actually are, better than others, or precisely know the truth.

We can all fall prey to this tendency in any profession, from doctors, engineers, lawyers and entrepreneurs to psychologists, bankers and even investors or advisors. In a nationally representative study conducted by Morningstar in early 2020, we surveyed more than 1,200 participants from the United States, and found that all participants had some level of the bias and nearly 67% were overconfident to an extent that it would impact their financial health and decision making. The younger groups (Gen Z and millennials) were found to be more overconfident than older groups (baby boomers and silent generation). Researchers state that this might be because as we grow older and become more experienced, we come closer to reality and estimate our abilities correctly.

Another research with Indian investors shows that those who earn high, have more dependents, share the earning responsibility, have high investment frequency, less time horizon, more investment experience and invest in large-cap stocks are more subject to the overconfidence. However, this study concludes that gender, age, and general education do not affect the level of overconfidence.

How overconfidence bias impacts our investment decision-making.

In the field of investing, numerous studies have shown how investors can be overconfident in their investing abilities. For example, Michael M Pompian through his book, Behavioral Finance and Wealth Management: How to Build Optimal Portfolios That Account for Investor Biases, found that once investors decide that a company is a good investment, they can become blind to the prospect of a loss and then feel surprised or disappointed if the investment performs poorly.

When investors are overconfident, they may feel that they can ‘beat the market’, in the absence of insider information or extraordinary skill. They tend to ignore the risk involved in an investment and, consequently, invest far more money than their less confident counterparts. These individuals also tend to under diversify because they believe in their knowledge and ability to handle a concentrated set of investments.

Additionally, they fail to acknowledge contradictory viewpoints or advice. Their belief in their ability to get in and out of stock and get good returns makes them trade excessively and they not only trade excessively, but also tend to buy overpriced assets, invest in risker portfolios, and have lower returns.

A study, Behavioral Biases, Investor Performance, and Wealth Transfers between Investor Groups, conducted on a very large dataset of nearly 2.5 million Indian investors, with nearly 1,346 million trades totalling monetary value of Rs 37 trillion between January 2005 and June 2006, shows that on an average, individual investors trade more than institutions but less than corporations, they hold riskier portfolios than institutions but less risky portfolios than corporations and the median value of the total returns of individual investors is statistically lower than that of non-individuals. In figures, the authors, Sankar De, Naveen R. Gondhi, and Subrata Sarkar, estimated a loss of Rs 8,376 crore during the sample period of 18 months, or Rs 5,584 crore per year. These losses were found equivalent to 0.77% of India’s gross domestic savings per year. Put differently, 0.22% of the Indian population lost 0.77% of the total gross domestic savings at that point in time.

Beyond trading behaviour, other indicators of financial health are also impacted by overconfidence.

Overconfident investors may not be well prepared for the future as they often overlook the potential risks related to retirement, like retiring early due to health issues and bearing heavy medical debt.  In the Morningstar’s study, compared to underconfident individuals, overconfident participants were spending more, had lower credit scores, and were less likely to save for the retirement.

Can we deal with this?

Beating the heat of any behavioural bias is not easy! But some simple behavioural techniques you can try for yourself and with clients that can help create an environment where you are less prone to becoming overconfident.

  • Pre-mortem your decisions

One technique is to look ahead at the challenges that could cause your plan to fail and create a plan to navigate it. How would this apply to investing? Imagine that you are tempted to invest in a hot stock, now imagine that you bought that stock, and the deal went wrong -- you realised that the stock did not carry sound fundamentals, or you could have invested in something more promising than this. This is not an exercise to identify all possible ways in which your decision can go wrong but thinking about such scenarios can foster the attitude of watchfulness and you will be quicker seeing you are going wrong.

  • Give reasons for your decisions

It’s easier said than done but giving reasons for your decisions -- understanding why that decision was made -- is as important as taking it. Taking the above example, ask yourself a couple of questions — why is this stock the best choice in comparison to others? What are some reasons to sell this stock? Does this investment contribute to my goals for investment?

  • Admit and reflect on your mistakes

Everyone makes mistakes. It’s important that we acknowledge and reflect on them on a regular basis. In investing, for example, spend some month/quarter and record what went well and what did not. For example, which investments were a good/bad buy and why? What decision-making process did you follow for each? What mistakes did you make along the way? And how can you avoid them in the future?

  • Take and trust expert advice

While taking any critical decision, such as choosing an investment, it is always advisable to take an expert opinion. For example, if you get tempted to buy a hot stock, just pause for a bit, ask your advisor, share your temptation, and seek his or her expert opinion. This can give you another perspective. Your advisor should evaluate the investment from different angles like their forward-looking ratings, quality of essential fundamentals of that company etc. Trusting expert advice is as important as seeking it, so make sure you trust them.

  • Educate yourself on overconfidence bias

Educating yourself about the prevalence of overconfidence and how it can impact our decisions is a great way to start combatting it.

The bottom line

Overconfidence is one of the many biases that can impact our financial decisions, and probably one of the hardest to correct. Overconfidence can creep into our decision-making processes and impact the way we address the basics of financial life like investing, budgeting, insurance, savings etc. It has the potential to leave us unprepared for the future and unhappy when not meeting our financial goals.

“Overconfidence is a very serious problem. If you don’t think it affects you, that’s probably because you’re overconfident.” – Carl Richards, CFP: New York Times “Sketch Guy” and author of The Behavior Gap.

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