This is my second in a series of deep dive articles on the most important behavioral biases that we confront as investors. In this week’s article I discuss overconfidence. It bears repeating that most investment pros have not read the original source material on the biases and thus are missing out on key nuances.

I think understanding these subtleties improves our ability to overcome the biases. Further, I believe that overconfidence is a source contributing to the emotions driving equity returns to the upside and is therefore a rich source of alpha. Last, my ultimate goal is to have this series culminate in a Theory of Behavioral Finance.

A Helpful Mnemonic Device: LOCHAARM

Though there are over a hundred biases formally identified I believe that there are less than ten that deserve the attention of investment professionals. It isn’t that the others are unimportant, it is just that many of them are corollaries of the major biases. These major biases are:

• Loss aversion
• Overconfidence
• Confirmation
• Herding
• Anchoring
• Availability
• Representativeness
• Mental accounting

A helpful mnemonic device for remembering these biases is LOC HAARM, brain lock that harms investment performance. Now to: overconfidence.

Overconfidence: Origins

A student of behavioral finance could be forgiven for believing that the biases the science identifies are recent discoveries. After all, in the literature that describes the biases only rarely is the history of the idea discussed. This is true for overconfidence. Cautions against overconfidence are millennia-old with admonishments about overconfidence featuring in Sun Tzu’s Art of War, for example:

“Don’t you know about the praying mantis that waved its arms angrily in front of an approaching carriage, unaware that they were incapable of stopping it? Such was the high opinion it had of its talents.”

Throughout history there are similar quotes cautioning against overconfidence. But what is new, in fact, is the mathematical measurement of the degree of this behavioral bias.

Overconfidence: The Findings, In Brief

Psychologists in the mid-20^th century began formulating ways of testing for overconfidence with papers appearing soon thereafter. Commonly people are asked to assess their confidence in their knowledge about something that is verifiably correct.

For example, Adams and Adams in 1960^[1] asked people their confidence in their ability to spell difficult words. If people in the aggregate stated, for example, that they were 75% certain they could spell a difficult word, but they only could 50% of the time, the difference is considered the degree of overconfidence.

Not surprisingly, people have been found to be overconfident in numerous studies, including research in which college students considered the likelihood of life events happening to them in comparison to their peers.^[2] The result was that they evaluated their chance of positive events happening to themselves much more highly than negative life events. They also expressed a higher degree of controllability about these factors than that which they ascribed to their peers.

While it may seem as if simply knowing about overconfidence as a bias is enough to avoid it, even psychologists have been proven to be overconfident in their diagnoses of patients.^[3] As investment analysts it is again tempting to simply log and note a heuristic with regard to this bias such as, “caution, you are likely overconfident most of the time.” But the discussion is much more nuanced than typically reported.

Overconfidence: Three Nuances

Those researching overconfidence have logged and noted three broad categories of overconfidence;^[4] they are:

• Overestimation
• Overprecision
• Overplacement

Overconfidence: Overestimation

Here the overconfidence is of the type described above in spelling difficult words. People overestimate their ability to complete tasks and report certainty or conviction in their answers. In investing many firms have intentionally created a culture where research analysts are hired and retained based on their conviction. Whereas, the data actually shows that decisions made with lower confidence tend to be better. Ouch! The reason is that a lack of confidence is directly linked to a full consideration of the factors that are leading to a prediction. By definition all predictions are subject to probability and uncertainty.

Within the overestimation sub-category there are several more nuances. They are: the illusion of control; planning fallacy; and contrary evidence. One path way for investors to reduce their anxiety and to improve their decision-making is to delineate the things that they can control and the things that they cannot. Believing that we have control of an outcome – like the magnitude of our investment performance results – when we do not is an example of the illusion of control. What we can control is our approach to investing. Interestingly, the data shows that most people do not overestimate their powers to control outcomes but underestimate them. Whoa.

Misestimating the length of time – shorter or longer – it takes to complete a task is the planning fallacy. I am entirely guilty of this bias, especially when doing public speaking. It has taken me years to speak for only the length of time I am allotted and not rambling well past it. Another version of this is over/underestimating the amount of work it takes to accomplish things. Within investing this bias may take on an entirely different form. Namely, over/underestimating the length of time it takes for an investment thesis to prove out or die out.

Last among the sub-categories of overestimation is contrary evidence. Sometimes this is known as wishful thinking. Where our confidence in an outcome is a reflection of how badly we need that outcome to happen relative to our desires. In our business value investors awaiting an inevitable mean reversion in securities prices, or a return to a normal monetary policy environment come to mind. “It just has to happen, because we need it to happen.” Said another way, you have to manage the world we have, not the world you wish we had.

Overconfidence: Overprecision

Within the scientific community there is criticism of the studies that attempt to measure, and thus prove, that overprecision is its own distinct sub-bias. Specifically, it is difficult to separate out overprecision from overestimation. One clever method of measuring this bias, though, is to ask people to put 90% confidence intervals around their outcome estimates. If they are correct in estimating their precision then 90% of their estimates ought to fall within the ranges offered. The gap would be overprecision.

In the investment business I think anecdotal evidence proves insightful here. How many of you investment pros out there are guilty of, or have seen others that are guilty of overprecision? This is overconfidence in the preciseness of predictions made. What immediately comes to mind are growth estimates taken to the tenth or even hundredth of a decimal point. “I believe XYZ is likely to grow 13.42% in calendar 2021.” Veterans among us know how silly this sounds. Heck, grizzled investment pros are happy to get the direction of most variables correct, let alone the magnitude. Think Buffett’s: “I would rater be roughly correct, than precisely wrong.”

Overconfidence: Overplacement

When we tend to think we are better than other people at tasks this is called overplacement. An example in the investment business are the slew of investment managers who believe they can beat their peers or benchmarks consistently. I could argue that the number of players in the active investment manager camp is strong evidence of overplacement. Even given the many flaws in studies that poo-poo active investment management, most firms still have marketing departments, not dissolution departments.

Other manifestations of this sub-bias include portfolio managers who believe they add value through security sizing choices. But the data is not kind. All you have to do to disprove this version of overplacement is to compare the performance of a fund to an equal-weight portfolio with, say, quarterly or annual rebalancing. Another example is the firm that has its own unique benchmarks by which they rate their performance as superior.

Conclusion

Overconfidence is probably as old as language, and the struggle against it nearly as long. By charting the nuances of the bias I have shown the way for beginning to overcome the biases. For a full diagnosis and treatment by me hire me out as a consultant and we can work on your firm’s behavioral biases and start to improve your performance.

[1] Adams, P.A., and J.K. Adams. “Confidence in the recognition and reproduction of words difficult to spell.” The American Journal of Psychology. Vol. 73, No. 4 (1960): 544-552

[2] Weinstein, Neil D. “Unrealistic Optimism About Future Life Events.” Journal of Personality and Social Psychology. Vol. 39, No. 5 (1980): pp. 806-820

[3] Oskamp, Stuart. “Overconfidence in Case-Study Judgments.” Journal of Consulting Psychology. Vol. 29, No. 3 (1965): pp. 261-265

[4] From https://en.wikipedia.org/wiki/Overconfidence_effect accessed 28 June 2018