Ever heard of the quote "too much of a good thing is a bad thing?" Well, this quote certainly applies to overconfidence.
But I Thought It was Good to Have Confidence!
It is. You need confidence when asking someone out and when walking down to get the mail in your slippers while your neighbors are out. So, similarly you also need confidence in YOUR own investments and decision making skills.
But while it is necessarily to have a degree of confidence as consumer confidence is key to a bull market, too much of it can be a bad thing. Overconfidence is a skewed perception of our intellect and an overvaluation of our performances.
Are Humans Arrogant?
Absolutely.
We tend to overestimate our abilities to estimate future performance and choose wise investments.
Especially if we have prior knowledge about a company, are feeling too optimistic, or extreme brand loyalty, this can lead to an unjustified amount of confidence. This can either result in an excessive amount of adding or trimming of a stock, holding winners too long, or having a less diverse portfolio due to an overconcentration on one industry. All of the following have something in common and that something in common is that they are damaging the investor’s ability to hone on his gains.
We are prone to over-evaluate our performance.
We assume that we are better at certain tasks than everyone one else is. Everyone knows that one student who thought they could pass the class without showing up to any of the lectures or studying. The same applies to analysts.
Montier's study demonstrated that the majority of market analysts believed that they were above average in their industry. The results of the study were that 74% of professional fund managers believed that they were above average while the rest believed that they were only average. It’s important to note that nobody thought that they were below average; everybody thought they were average or above average.
Thirdly, we are vulnerable to overprecision. This happens due to the fact that we over-evaluate our performance. Because we think that we have better information or know more, we tend to underestimate what could go wrong since we are focused on the opposite-what could go right.
Are you guilty of being overconfident?
Sources & Suggested Readings