Behavioral Finance and Your Portfolio

17Emotional Bias #2: Overconfidence Bias

Too many people overvalue what they are not and undervalue what they are.

—Malcolm S. Forbes

Bias Description

Bias Name: Overconfidence

Bias Type: Emotional

General Description

In its most basic form, overconfidence can be summarized as unwarranted faith in one's intuitive reasoning, judgments, and cognitive abilities. Although the concept of overconfidence derives from psychological experiments and surveys in which subjects overestimate both their own predictive abilities and the precision of the information they've been given (essentially cognitive weaknesses), these faulty cognitions lead to emotionally charged behavior, such as excessive risk-taking, and therefore overconfidence is classified as an emotional rather than cognitive bias. In short, people think they are smarter than they actually are and have better information than they actually do. For example, they may get a tip from a financial advisor or read something on the Internet, and then they're ready to take action, such as making an investment decision, based on their perceived knowledge advantage.

Examples of Overconfidence Bias

Prediction Overconfidence

Roger Clarke and Meir Statman demonstrated a classic example of prediction overconfidence when they surveyed investors on the following question: “In 1896, the Dow Jones Average, which is a price index that does not include dividend reinvestment, was at 40. In 1998, it crossed 9,000. If dividends had been reinvested, ...