Behavioural Finance, Part 6: Overconfidence and Under-Confidence

Welcome to Part 6 of our Behavioural Finance series.

If you’ve missed the earlier parts of the series, you’ll find our Introduction to Behavioural Finance here, Part 2: Prospect theory and loss aversion here, Part 3: Availability and Representativeness here and Part 4: The Law of Small Numbers here and Part 5: Anchoring, Conservatism and Herding here.

For the next two weeks in our 10-week series on behavioural finance, we’ll be looking at the problems surrounding self-evaluation. This is where we need to judge our own skills, knowledge and competence related to investment decisions, to gauge how confident we can be in our own actions.

Self-evaluation is how we build an understanding of our own successes and failures – whether we think our actions are responsible for them, or if they’re down to factors beyond our control. It can be one of the most difficult areas for us as individuals to address because how we evaluate ourselves is driven by deep-seated personality traits and our sense of self-confidence.

Overconfidence

As you can imagine, overconfidence is not a trait that applies only to those with an interest in investing. We’re all guilty of overestimating or exaggerating our chances of success in any number of personal or professional situations. Overconfidence isn’t driven by incentives, it is innate — which makes it all the more powerful in its influence on our behaviour.

Instances of overconfidence are everywhere, inside and outside the world of finance. Some examples at play can reveal a minefield of blind spots. How many times in our lives have we taken part in a competition or entered a contest with the belief that we could end up actually winning it, despite a host of other competitors and the fact there can be only one winner? Much of competitive sport is driven by every single participant sharing this same belief.

Surveys regularly show up results where well over half of the respondents rate themselves as comfortably above average, which would be statistically highly unlikely. (One of my favourites is the finding that 84% of French men estimate that they are above-average lovers 1). Drivers also regularly rate themselves as above average, in numbers far higher than 50%. Entrepreneurialism in our society would be far lower without the potent hit of overconfidence that powers the launch of so many new ventures and start-ups.

When it comes to investing, commentators have claimed that ‘no problem in judgment and decision-making is more prevalent and more potentially catastrophic than overconfidence’2. In an adviser’s experience, overconfidence and trying to be too clever in investing can often lead to too much tinkering with the portfolio. Clients who stick to their agreed plans are the ones most likely to reap the best long-term rewards. Looking for quick gains can often undermine or even destroy the capacity for growth over the life cycle of an investment.

Overconfidence is common in many situations and can arise for a number of reasons, as Professor Kahr explains:

“People who present as overconfident might, in fact, be hiding significant insecurities and anxieties. They project an aura of omnipotence as a creative defence against impotency. Such a character style might stem from not having had sufficient confidence in one’s sense of self, which generally derives from security of attachment in early childhood. Most people will struggle with a sense of confidence at some point, as all of us began life as fragile babies. But in adulthood, the failure to accept advice from a specialist may be a reflection of fear and vulnerability. The capacity to receive advice from an expert adviser may very well be a good barometer of mental health.”

Under-Confidence

While not as prevalent and pervasive as overconfidence, under-confidence can also have a detrimental impact on our investment activity. Research has shown that individuals can underestimate their abilities and chances for success when making decisions about what investments to choose. There are particular examples of investors being too conservative about their own performance relative to that of other people. We can also just be pessimistic, tending to think there’s a greater probability of something bad happening to us than the average. Under-confidence as a whole can lead to inactivity and a reluctance to take on the level of risk necessary for an investor’s long-term financial lifestyle goals.

On a day-to-day basis, we find that bad past experiences can also leave investors with an under-confidence that is difficult to shake. They might have been inappropriately advised, taken on too much risk, or had their fingers burnt after investing unwisely. This can often result in a client keeping all their funds in cash for fear it might happen again, which can be a frustrating and unrewarding position to find yourself in. The presence of a trusted and experienced financial adviser is vital to help clients navigate their way through the peaks and troughs of overconfidence and underconfidence that all investors experience.

We formulate a plan which covers all elements of our client’s financial position. It’s not vital that they understand all the minutiae and financial technicalities, but it is important that clients know a plan exists and has been created uniquely for them. Having a long-term financial plan that is linked to their life goals should give investors the confidence that they can commit to achieving the financial lifestyle they’re seeking.

If you would like some help in planning your ideal financial lifestyle, please feel free to get in touch.

Questions to Ask Yourself

How strongly do you agree or disagree with the following statements?

• I still have high hopes for my investments, even in the face of some failed investment decisions I have made in the past.
• I often feel that I have little influence over the things that happen to me.
• I am better informed about current financial conditions than the average person.
• I am good at making financial decisions.

Next post: Self-Serving Bias. 

1 Source: Taleb, 2012
2 Source: Plous, 1993, p. 217

This document is marketing material for a retail audience and does not constitute advice or recommendations. Past performance is not a guide to future performance and may not be repeated. The value of investments and the income from them may go down as well as up and investors may not get back the amount originally invested.