Beware of Overconfidence Bias

Beware of Overconfidence Bias

In 2006 James Montier, a researcher at the investment banking arm of Dresdner Bank, decided to test the behavioral biases of some 300 investment fund managers. One of the questions he asked was “Are you above average at your job?” Over 70% of the respondents answered yes. A number even included comments along the lines of “I know everyone says they are, but I really am!” Most of the remaining respondents considered themselves average, with only a small fraction reporting themselves as being below average.

The source of these results is a behavioral bias called overconfidence. It is an egotistical belief that our skills, intelligence, or talent is better than it actually is. This is not to be confused with narcissism, a personality disorder in which, according to the Mayo Clinic, a person has an inflated sense of his own importance, a deep need for excessive attention and admiration, and a lack of empathy for others. (Does this sound like someone well-known in Washington?)

Although overconfidence bias is prevalent throughout all types of businesses, it can be especially problematic when exhibited by financial services professionals. After all, one of the highest-value benefits financial advisors provide is helping clients manage the risks associated with their investment and other financial decisions. Overconfidence can lead us to view those risks as less significant than they actually are.

One manifestation of overconfidence bias is the illusion of control. In the investment world this takes the form of forecasting future security prices using some kind of heuristic (e.g. technical analysis). The assumption is that the forecaster has knowledge of what controls those prices in the capital markets. Study after study refutes the ability of anyone to consistently predict anything, let alone security prices, with any statistical significance beyond plain luck. Despite the overwhelming evidence, there is no shortage of pundits in the financial media making predictions right and left as if they know what is going to happen.

Another variant of overconfidence is overestimating the likelihood of a particular outcome occurring simply because it’s the outcome we’d prefer. This is commonly thought of as wishful thinking and is ubiquitous in many ways. Have you ever resisted selling a mutual fund you were holding at a loss because you wanted to wait for its value to come back to what it was when you bought it? Loss aversion (another financial bias) is what makes you resist selling it, and wishful thinking is what causes you to expect the fund’s price to increase without any other basis for such an assumption.

In my view financial advisors should constantly be testing our beliefs and expectations. When making recommendations we should always consider alternative scenarios and be prepared to recognize when market or economic changes might be invalidating previously-held assumptions.  We must be able to recognize our own biases when advising others, or we will find ourselves part of Montier’s 70% while providing advice that is actually well below average.

Here’s a link to Montier’s paper: https://papers.ssrn.com/sol3/papers.cfm?abstract_id=890563.

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