Contrary to traditional economic theory, investors are not completely rational human beings. Instead, they are also emotional. This also means that they feel joy when they succeed and pain when they fail. This is the reason that when some investors succeed continuously for a small period of time, they start becoming overconfident. In behavioral finance, this bias has been identified and named as "overconfidence bias." It is one of the most dangerous biases possible and has led to investors losing millions of dollars.
In this article, we will understand what overconfidence bias is and how it impacts the decision making of investors.
What is Overconfidence Bias?
Overconfidence bias can be defined as an unwarranted and often times illogical faith that an investor has in their ability to predict the market. Some investors believe that they are somehow gifted and have special intuition and reasoning skills that help them predict the outcome of the market. This could be because they believe that they have some special skills. Alternatively, they might also falsely think that they have access to superior information, which is why their decisions will always be better. In simpler words, overconfidence bias is a belief amongst investors that they are smarter than everyone else!
This bias is remarkably prevalent in the investment community. There have been studies conducted wherein investment professionals have been asked to rate their investing acumen vis-a-vis other investors. In such studies, about 75% of investors have ranked themselves as above average! On the other hand, the other 25% have ranked themselves as average. The interesting thing is that generally, no one ranks themselves as below average!
Types of Overconfidence Bias
Over the course of the research, two different types of overconfidence bias have been identified. The details of these biases have been written below:
Certainty Overconfidence: Certainty overconfidence is the perceived ability of the investors to actually pick the next big stock with absolute certainty. These investors often believe that they have some kind of acumen, which allows them to pick the next winner at a very early stage. Also, sometimes investors fall prey to the notion that the quantity of information received about an investment increases the quality of decision being made about it. The reality is that even if investors have more information about a prospective investment opportunity, it is unlikely to increase the efficiency of their decision making.
Prediction Overconfidence: Prediction overconfidence is the behavior of investors wherein they tend to make very narrow predictions. This means that while predicting values, they assign a very narrow range. For instance, an investor may believe that the GDP of the USA in the next year will only change between negative 2% and positive 3%. This may be a case of prediction overconfidence if data shows that GDP can vary between negative 10% and positive 10%! Prediction overconfidence bias makes investors falsely restrict the possible outcome to a very narrow range.
Impact of Overconfidence Bias
Overconfidence bias may have a lot of negative impact on the investment decisions made by an investor. Some of the shortcomings have been listed below:
Search for Multibagger Stocks: Investors with overconfidence bias often tend to believe that they can pick the next big stock. As a result, they often invest in a lot of risky penny stocks. They do some analysis or receive some information about a company which makes them believe that they are special. Therefore, they invest in risky stocks, and a lot of times, this ends up destroying the value of thier portfolio.
Trading too Often: Investors with overconfidence bias are known to trade excessively. This is because they often believe that they are in possession of some special knowledge that other investors are not aware of. However, it is a known fact that trading too much can be detrimental to investors well being. This is largely because of the transaction costs involved. However, it can also be detrimental because if an investor trades too often, they are more likely to end up picking some wrong stocks.
Ignore Negative Information: Overconfidence bias hinders the ability of an investor to factually evaluate any investment. Their thoughts are always biased, and their decisions are made based on emotions instead of being based on fact. This is the reason that investors often continue investing even after they may receive negative information about a company. Investors with overconfidence bias are far more likely to ignore negative information since they believe that they already know whats best.
Underestimate Risks: Investors with overconfidence bias are known to not pay attention to empirical stock data before they make any investments. This is the reason that they often underestimate the risks involved in their investments. Overconfident investors are known for holding portfolios that are less diversified. As a result, when the markets start to turn red, these investors often end up facing the biggest losses.
Overconfidence bias can be difficult to avoid. This is because whenever an investment decision is being made, investors are confident because of the research that they may have done. However, a lot of time, this confidence may be the result of a biased analysis. From an investors point of view, differentiating between confidence and overconfidence is almost impossible. This is what makes investing difficult, as well as interesting.
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