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  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
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