1. Behavioral Finance: Introduction
  2. Behavioral Finance: Background
  3. Behavioral Finance: Anomalies
  4. Behavioral Finance: Key Concepts - Anchoring
  5. Behavioral Finance: Key Concepts - Mental Accounting
  6. Behavioral Finance: Key Concepts - Confirmation and Hindsight Bias
  7. Behavioral Finance: Key Concepts - Gambler's Fallacy
  8. Behavioral Finance: Key Concepts - Herd Behavior
  9. Behavioral Finance: Key Concepts - Overconfidence
  10. Behavioral Finance: Key Concepts - Overreaction and Availability Bias
  11. Behavioral Finance: Key Concepts - Prospect Theory
  12. Behavioral Finance: Conclusion

By Nathan Reiff

A landmark study entitled “Behaving Badly” is a useful introduction to our next source of bias and irrational behavior: overconfidence. In 2006, researcher James Montier found that a whopping 74% of 300 professional fund managers he surveyed believed that they had delivered above-average job performance. The majority of the remaining 26% of those surveyed believed that they were average in their performance. Nearly 100% of those surveyed felt that their performance was average or better. In actuality, of course, only 50% of a sample can be above average. This discrepancy suggests that many of these fund managers displayed an irrationally high level of overconfidence. (For related reading, see 8 Psychological Traps Investors Should Avoid)

Overconfidence reflects the tendency to overestimate or exaggerate one’s ability to successfully perform a given task, and it is a trait that is common among people in all professions and areas. To illustrate this, consider the number of times that you’ve participated in a competition or a contest with the attitude that you have what it takes to win, regardless of the number of competitors in the field or the fact that most competitions have only one winner.

While confidence can be a beneficial thing, overconfidence is often detrimental. The distinction between the two is subtle and often difficult to assess; confidence suggests a realistic trust in one’s abilities, while overconfidence implies an overly optimistic assessment of one’s knowledge or level of control over a particular situation.

Overconfidence in Investing

Overconfidence can be harmful to an investor’s ability to pick stocks over the long term. A 1998 study entitled “Volume, Volatility, Price, and Profit When All Traders Are Above Average,” written by researcher Terrence Odean, illustrates this. The study found that overconfident investors typically conducted more trades as compared with their less-confident counterparts.

Perhaps unsurprisingly, overconfident investors believed that they were better than others at picking the best stocks and times to enter or exit a position. Odean also found that traders conducting the most trades tended, on average, to actually receive yields significantly lower than the market. (To learn more, check out Understanding Investor Behavior.)

Avoiding Overconfidence

To avoid overconfidence, it can be useful to remember that even professional fund managers and traders with access to the best reports and computational models still struggle to achieve market-beating returns. Those fund managers who maintain realistic estimations of themselves and their abilities know that every investment day offers a new set of challenges and that no investment technique is perfect. Indeed, most overconfident investors are only a trade away from a very humbling wake-up call. (For more, see 4 Behavioral Biases and How to Avoid Them)

Behavioral Finance: Key Concepts - Overreaction and Availability Bias
Related Articles
  1. Investing

    What Happens When You Trade Often and Time the Market?

    This is how market timing and frequent trading can negatively impact returns.
  2. Investing

    4 Reasons Why Selling Is Harder Than Buying

    Understand why selling stocks is harder than buying them, and develop strategies for establishing investment goals with price targets.
  3. Investing

    10 Ways to Profit Off Stock Volatility

    As markets turn volatile, here are 10 tips that every beginning day trader should know.
  4. Financial Advisor

    How and Why Our Investing Habits Matter

    Habits are not created or broken in a day, but through consistent choices we can develop healthy habits that will aid us through a lifetime of investing.
  5. Investing

    8 Psychological Traps Investors Should Avoid

    There are a number of very common psychological traps or errors that investors typically make. You can save a lot of money and misery by avoiding them.
  6. Investing

    Using Market Corrections to Evaluate a Portfolio

    A small market correction is a great time to evaluate if your portfolio and retirement savings are on the right track.
  7. Investing

    Behavioral Finance and the 4 Stages of Bull and Bear Markets

    Step into the psychological aspect of investing. Just as investor behavior can be irrational during bull markets, bear market cycles may also exemplify unique cognitive biases.
  8. Personal Finance

    Costly Personality Traits In Financial Planning

    For people to be successful with their finances they must plan effectively. However, sometimes negative personality traits can hold people back.
  9. Trading

    Understanding Investor Behavior

    Discover how some human tendencies can play out in the market, posing the question: are we really rational?
  10. Investing

    Investors Move to Cash in February: Merrill Fund Manager Survey

    With stocks selling off in the beginning of February, fund managers around the globe moved to cash.
Frequently Asked Questions
  1. What are some examples of horizontal integration?

    Some recent, real-life examples of horizontal integration.
  2. What does the current cost of living compare to 20 years ago?

    Find out how inflation has affected the dollar since 1998, and how the cost of living has changed above and beyond what can ...
  3. What does negative shareholders' equity mean?

    A negative balance in shareholders' equity, also called stockholders' equity, means that liabilities exceed assets and can ...
  4. Are retained earnings listed on the income statement?

    Retained earnings are the cumulative net earnings or profit of a company after paying dividends and can be reported on the ...
Trading Center