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Behavioral Finance 101 - Overconfidence

2020.9.28 Luis Silva

A lot of people are overconfident. This trust leads people to overestimate their knowledge and ability to control investment results as well as underestimating the risks.

In a well-known study(1), a questionnaire was given to university students on whether they thought their driving ability was above average. 82% of students thought they were driving better than the average driver, something that is statistically impossible.

In many aspects of our lives this overconfidence has no negative impacts and may even be positive. There would hardly be so much innovation or new businesses if people didn't take the risk and had the confidence to do it, from a new cafe to SpaceX(2).

However, the problem is when this overconfidence biases our decisions. When we find that regardless of all evidence to the contrary, we will achieve a return well above average, leading to more transactions in the portfolios(3) and potentially more errors.

Another problem that comes with overconfidence is that we ignore all (or a significant part) of what is in opposition to our view of ourselves. Thus, when our investments go well, we attribute the results to our good analytical skills, but when they go wrong, we end up blaming the “irrationality” of the markets.

Don't feel bad if this has already happened to you. They are in good company. Both Isaac Newton(3) and Keynes(4) have already justified investment losses in this way.

 

The problem is when this overconfidence skews our decisions.

 

But it is not just in returns, or in trying and getting higher returns, that overconfidence can complicate life for an investor. If the investor assumes that he accepts more risk than he is actually comfortable with, he can make the foundations on which the investment plan rests based on wrong assumptions. This can not only lead to sales at the most inappropriate times but also unwanted stress. I think this year was a good time to test the risk we feel comfortable with. Some investors have realized, of course, that a 30% loss on an excel sheet or backtest is a little different when we are in the market and we are losing money in real time.

We must fight against this overconfidence through the analysis of what is really in its genesis, Illusion of knowledge and illusion of control.

Some of the best examples of the illusion of knowledge by being “disassembled” simply by asking how seemingly simple things work, even a bicycle(5). People confuse familiarity with understanding.

On the other hand, the illusion of control, and how much we actually (don't) have, is well explored in books such as Fooled by Randomness: A Hidden Role of Chance in Life and The Drunkard's Walk: How randomness rules our life. Overconfidence in our abilities, together with the need to create a causality to the various events that surround us, lead us to underestimate the randomness of life and to think that we have more control than we really do. No matter how good a plan we have for our business, 2020 is being an atypical year that most likely invalidated it.

It is not right that knowing our limitations makes us magically let them go. But educating ourselves about them is definitely a step in the right direction.

 

Note on title:

The expression 101 is taken from the Anglo-Axon world. It is associated with the basic version, with the initial concepts of a topic. Wikipedia

 

Referências:

Luis Silva
Luis Silva

With a degree in economics (2006) and a postgraduate degree in Finance from Universidade Católica do Porto (2010), he later realized that he shared the same enthusiasm for programming.

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