Overconfidence Bias

Overconfidence bias refers to the tendency of people to have excessive confidence in their abilities, knowledge, and ideas. It is an example of a cognitive bias affecting the success in the life of people.

It can happen irrespective of gender, age, experience, or field of knowledge. The overconfidence level in individuals may vary. Some people have more of it, and some have less of it. For example, a significant portion of Americans thinks they have above-average intelligence. They demonstrate overconfidence in their knowledge and abilities.

• Overconfidence bias in psychology refers to the tendency of people to overestimate their abilities.
• It influences people to judge themselves better than others. As a result, people possess high regard and favorable view toward their abilities and reasoning.
• It consists of four types: Over ranking, the illusion of control, timing optimism, and desirability effect.
• It is a difficult characteristic among many people making them invite loss by creating high-risk decisions and actions in their day-to-day lives.

Overconfidence bias psychology is a general tendency of people to overestimate their skills, authority, and knowledge due to excessive confidence. It can affect their thoughts, decisions, and strategies associated with particular tasks, strategies, and outcomes.

Thus, the individual chooses to accept something that they believe is above the actual truth. They totally depend on their own decision, estimation and understanding rather than being open-minded to the real facts. In today’s world, every information is having a lot of personal opinion and idea attached to them which tends to distort the actual situation. It is important to be informative and ready to change or preconceived ideas and beliefs that leads to overconfidence bias psychology.

In finance, entities' overconfidence based on past and present success can lead to poor decision-making. The overconfidence effect can affect the rationality present in the investors. It also influences investors to indulge in trading to achieve higher returns actively. However, they often fail to get higher returns. In other words, this leads to significant losses. Therefore, investors should keep check on their understanding and be flexible and confident and not overconfident in their decision,

Let us look at different types of overconfidence bias in finance:

#1 - Over Ranking

It is a simple practice where people tend to overrank themselves as better than they are because no one likes to imagine themselves below average. People perceive themselves as dominant. Therefore, they can rate themselves much more than they are. So in a general sense of ranking, people tend to hide their true abilities and end up ranking themselves at least better than the average. This way, overestimating the abilities can result in taking too much risk and making heavy losses.

#2 - Illusion of Control

Everyone likes to control and imagine that they can and try to control situations. It is a very common human behavior where people usually think they operate with a sense of control. Still, in real cases, they cannot control or exert power as anticipated. It is highly dangerous when people fail to assess their authority and believe they are in total control of the circumstances. This simple trait can be very distressful and loss inviting in business and investing.

#3 - Timing Optimism

It occurs when people tend to, without any evidence, underestimate the time and effort required for them to finish a task. It can be mapped to a part of optimistic behavior, and it is wonderful to believe in our abilities and forecasting to view the world positively. However, optimism over how long something will take you to complete can be harmful in certain situations.

#4 - Desirability Effect

It is when people have a strong belief that nothing will go wrong. They expect and believe that the desired outcome will happen. It points to the overestimation of the likelihood of the ideal result.

Let's look into overconfidence bias in finance examples for better understanding:

Example #1

GGP Inc. is an American commercial real estate company. In 2009, it was the subject of the biggest real estate bankruptcy in American history. GGP owned more than 200 malls at its height, and its stock was trading favorably. However, the business was saddled with debt in 2008, with a sizable portion of that debt coming due.

In addition, the company faced difficulty refinancing its debt following the market's collapse of the commercial MBS. As a result, its shares sharply declined, and the business declared bankruptcy. The corporation had numerous chances to generate money by selling equity, but affected by overconfidence bias behavioral finance lost the chance to sell shares profitably.

Example #2

Overconfidence bias investing can result in poor investment decisions. It is one of the reasons amateur investors fail when they attempt to time the market influenced by market highs and rallies. So it was when many investors highly advised that people and new retail investors must not let the bullish trend in the market influence them and take risks they could not afford out of overconfidence.

It is easy to get influenced when people see their money getting double and triple within a few days. Still, anyone and everyone must have rational thinking and not let overconfidence take their driving wheel.

• Seek information that contradicts the findings.
• While making decisions, first of all, people should think of the end goal and outcome and what will happen if things don't turn out as expected. What if this went wrong; what if that didn't go well; studying every possible detail or last-minute error refines the overconfidence bias behavioral finance into a critical thinking aspect.
• Whenever there finance and money are involved, people should always keep an open mind, be humble about scenarios and be sincere about constantly checking things to ensure they are moving according to the plan.
• One of the most crucial habits to overcome is learning from one's mistakes. 
• Another important practice to overcome overconfidence bias investing in decision making is to accept feedback and peer review and execute them. When people give their advice and opinion, it is always good to listen to them; this way, it is respectful and insightful, and at the same time, it is learning from other people's experiences.
• Fear can be healthy. It can create a driving force that stops people from making bad, quick, and reckless decisions.

This type of bias can be avoided through many techniques and procedures, as follows:

• Rather than staying fixed on one particular approach, it is necessary to be flexible. Flexibility helps us to remain open-minded to the actual situation and the different possible approaches that are available to solve the problem or handle the situation. In investing, there may be many methods to achieve one goal. It is necessary to evaluate exach of them.
• Reflection is another important aspect that investors should understand. It is a very important skill where the investor should try to assess the situation from an outsider point of view and then take an informed decision in order to avoid overconfidence bias.
• Information gathering helps in staying informed about the necessary changes taking place in the investment world related to rules and regulations, trends, procedures, etc. A well informed investor has less chance to become overconfident because they have the mindset to learn new things.
• Being skeptical helps in finding out more information to increase awareness and also find loopholes, frauds and misstatement so that any bias towards any particular situation or decision can be avoided.
• It is important to allow our mind to take in multiple perspectives of a situation because it impacts our decision-making process to a great extent. While working, everyone has different perspectives and approaches to deal with a matter. In investing, there are similar situations too. It is essential to consider other’s ideas and opinions so as to avoid unnecessary biases.

Thus, the above are some important ways to avoid this kind of bias.

Both the above a two forms of cognitive biases that affect the decision making process. However, it is necessary to understand the difference between them,

• The former refers to the extreme confidence in an individual’s own belief and idea, whereas the latter refers to the thought that they could have prevented a situation from happening after it has already happened.
• The former refers to overestimation of one’s skill, knowledge and judgement whereas the latter refers to the overestimation of their ability to predict the future.
• The former has the tendency to disregard the actual facts and figures where the latter refers to the tendency to distortion of past situations and accepting them to be more consistent than they actually are.

This has been a guide to what is Overconfidence Bias. We explain it with examples, how to overcome, how to avoid, differences with hindsight bias & types. You may also find some useful articles here:

• Optimism Bias
• Hindsight Bias
• Status Quo Bias