Ever have a toxic girlfriend or a boyfriend? Or even a toxic friend?
Well similarly, overconfidence is extremely toxic to risk management.
Why?
Because an over-assessment of skills can lead to the overestimation of positive financial outcomes rather than poor ones. In other words, because they are overconfident (#bigego), someone will be much more likely to take on more risk than they normally would. Subsequently, individuals with this overconfidence bias are much more optimistic and see much more of the positives of financial outcomes rather than its risks. Correspondingly, this leads to an overestimation of the good rather than the bad.
What is Risk Management?
Risk management is the process of identifying and controlling threats to either an organization or individual’s capital. For an organization, such risks could vary from legal liabilities to errors in management to its digit assets.
For individuals, however, risk often means the possibility of a financial loss. So for example, risk management occurs when a fund manager takes into account a client’s risk tolerance and quantifies them in order to take the necessary actions to minimize such risks.
Inadequate risk management can lead to disastrous results. The subprime mortgage crisis in 2007 that catalyzed the Great Recession of 2008 occurred due to poor risk management. Lenders extended loans to individuals with poor credit, investment firms such as Bear Stearns bought and resold mortgages that were essentially worthless, and private equity firms invested heavily in such mortgages. All of this revolved around the idea that the housing investing bubble would never pop and when it did, it unleashed effects that the global economy would still face years later.
Under-confident clients are highly likely to be more susceptible to the status quo bias. But as mentioned before, excess confidence can lead to a dangerous amount of risk-taking. But as with anything related to finance, it’s crucial to take into account other behavioral aspects such as loss aversion and how individuals deal with the threat of uncertainty.
It's not just overconfidence that can lead to poor decisions. Other concepts such as mental accounting and herding can also too.