O is for Overconfidence

Overconfidence is highly underrated as a cause of poor investing behavior. You see, almost no one believes that they, themselves, are overconfident. Generally we're very confident about the fact we're not overconfident. Generally we're wrong.

Example

One of the problems with overconfidence is that we don't really know what it means: that you consistently think you're above average. In one experiment Ola Svenson showed that 93% of Americans thought they were a better than average driver. Most of us if we take one of the various online overconfidence tests will fail it (I just did). We'll usually put this down to bad luck, but as we're being asked to forecast a range it's not: we're fooling ourselves about the extent of our own knowledge and abilities.

Famously Brad Barber and Terry Odean showed that a large sample of online investors consistently lost money by trading stocks. They'd have done far better doing nothing, yet they traded on, seemingly oblivious to the fact they were throwing money away. And, to be honest, they probably didn't know: many investors have no idea how they're actually doing compared to the market. They're confident that they know, of course, but usually they're wrong.

Causes

Barber and Odean suggest that self-attribution bias - success is down to us, failure is down to someone else - plus the illusion of control and an illusion of knowledge combine to cause overconfidence. More generally, looking on the bright side of life is probably essential for an even vaguely normal person, so it's an understandable trait. But in all likelihood what's happening is that we tend to only do things that give us positive feedback, so we become used to being successful. Even if we fail we know what we really meant - this is the introspection illusion in action, and it leads us inevitably into temptation.

Mitigation

Experience really helps with overconfidence. More experienced investors diversify more widely and trade less often. You wouldn't think that was too hard to take on board, but every generation of new traders has to learn the hard way. But you can do better, than that, can't you? Hmm ...

And also: Overconfidence and Overoptimism

Read more: A Liberal Arts Investor's Reading List

The A to Z of Behavioral Bias