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Learning outcomes.
After completing this video you'll be able to explain what overconfidence bias means,
differentiate between prediction overconfidence and
certainty overconfidence.
Overconfidence bias.
In its most basic form, overconfidence bias can be summarized as
unwarranted faith in an investor's intuitive reasoning,
judgment, and cognitive abilities.
Investors typically overestimate both their own prediction abilities and
the precision of the information that they have been given.
In short, investors like me think that they're smarter than other investors and
have better information than they actually do.
For example, I may get a tip from a news service or read something on the Internet,
and then I'm ready to take an investment decision such as going and
buying a stock, going long a stock, based on my perceived knowledge advantage.
So I can be overconfident in my investment abilities.
More specifically, the confidence interval that I may assign to my investment
predictions maybe far too narrow than what they should actually be.
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The implication of this behavior is that I, as an investor,
may underestimate the downside risk to my portfolio.
Moreover, I may be certain about my judgments.
For example, if I resolve that a company is an extremely good investment,
I may often be aloof to the prospect of a loss and then feel surprised or
disappointed if the investment performs poorly.
Now this type of overconfidence is called certainty overconfidence, and
this kind of behavior results in a tendency to fall prey
to a misguided quest to identify the next big stock.
So if I'm susceptible to certainty overconfidence,
then I may be trading far too often or
too much in my account, and may hold portfolios that aren't diversified enough.
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Now let me give an example, a practical example, of prediction overconfidence.
In a survey for
a research project, investors were asked the following question.
The question was that, in 1896, the Dow Jones Industrial Average,
which is basically a price-weighted index
that does not include dividend-free investment, was at 40.
Now in 1998, it had crossed 9,000.
So the question that was asked was if dividends had been reinvested, investors
were asked what did they think the value of the Dow Jones index would be in 1998?
In addition to that, they were asked to guess and predict a low range so that they
felt 90% confident that their answer is between their high and low guesses.
Now in this survey,
very few responses reasonably approximated the potential value of the Dow Jones.
And in fact, no one, actually no one estimated a correct confidence interval.
Now if you're curious, the 1998 value of the Dow Jones Industrial Average,
under the condition that you actually reinvested the dividends back,
would have been an amazing 652,230.
Now in 1998 it was 9,000, but if you had reinvested the dividend,
it would have become 652,230 instead of 9,000.
This is a classic example of investor prediction overconfidence.
Now let me give an example of certainty overconfidence.
Certainty overconfidence is actually quite common in the investment arena in
the sense that, if I'm an investor,
I may tend to have too much confidence in the accuracy of my judgments.
Now if I find out more about a situation,
the accuracy of my judgment is not likely to increase.
But as an investor, my confidence starts to increase because as an investor,
I mistakenly equate the quantity of information with its quality.
A classic example of certainty overconfidence occurred during the tech
boom of the late 1990s and early 2000s.
A lot of investors simply loaded up on technology stocks,
holding highly concentrated positions,
only to see the gains vanish during the subsequent meltdown in 2001.
So just to sum up, both prediction and
certainty overconfidence can lead investors to make mistakes.
Overconfident investors overestimate
their ability to evaluate a company as a potential investment.
Therefore, they may become blind to any negative information that might
normally indicate a warning sign that either a stock should not be purchased or
a stock that was already purchased should be sold.
If I'm an overconfident investor, I may trade excessively as a result of believing
that I possess some special knowledge that others don't have.
Excessive trading behavior has proven to lead to poor returns over time,
because I either don't know or don't understand or don't heed to the investment
performance characteristics if I'm an overconfident investor.
I can also underestimate the downside risk.
As a result, I can unexpectedly suffer poor portfolio performance.
Overconfident investors tend to hold under-diversified portfolios,
thereby taking on a lot more risk without a commensurate change in risk tolerance.
If I'm an overconfident investor, I may not even know that I'm
accepting more risk than what I would normally tolerate.
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Vaidya NathanLecturer
