Overconfidence bias

What is overconfidence bias?

_{Caption: Overconfidence bias could make us think we are more talented than we are. Photo: Vitalii Vodolazskyi/Shutterstock}

Overconfidence bias is the tendency to overestimate one’s own abilities and knowledge, leading to overconfidence in decision making. The overconfidence bias in finance could be detrimental for traders, as it could cause them to make mistakes which, in turn, could lead to them making losses.

Highlights

Causes of overconfidence bias

In order to define overconfidence bias, it is important to understand some of the causes. These could include:

• Doubt avoidance. Very often people don’t like moments where there is ambiguity, or doubt. Overconfidence could work as a solution to that, with the overconfident person feeling like they have enough confidence in their abilities to feel certain, even in a situation where they should feel doubtful. 

• Inconsistency avoidance. A lot of the time, people search for consistency when it comes to new ideas. There is a tendency to search for a link between previously held beliefs and new ones. This may lead people to try to hold onto their old ideas, even if new evidence contradicts them. 

• The endowment effect. This is a phenomenon where people overvalue things purely because they own them, and could feed back into overconfidence. 

• Hindsight bias. Hindsight bias, the false belief that they saw something happening before it happened when they didn’t, could lead to overconfidence. 

• Incentives. Sometimes, the higher an incentive someone has for doing something the more determined they are to get it done. This could make them believe they have made the right judgments and have the correct set of skills to get it done, even when they don’t.

Types of overconfidence bias

Overconfidence can come in various forms, including:

• Illusion of control

This type of overconfidence bias refers to the belief that someone has more control over a situation than they actually do. In trading, it could lead to traders believing they can control the market, when they can’t.

• Over ranking

This refers to the belief that someone is more talented than they actually are. This is pretty common, largely because no one wants to believe that they are below average. In trading, this could lead to traders making trades based on overly optimistic forecasts, culminating in potential losses.

• Timing optimism

This is when someone incorrectly thinks they could do work far quicker than they actually are able to. This relates to trading when traders think that a trade or investment would pay off far quicker than it actually could. 

• Desirability effect

Perhaps better known as wishful thinking, this is when someone thinks that something is going to happen, purely because they want it to happen.  

Overconfidence bias examples

These are some hypothetical cases where trades could go wrong because traders have fallen victim to the overconfidence effect:

• Believing an asset’s price will continue moving in the same direction

An example of overconfidence bias in trading is when a trader believes an asset will continue to move in a way that benefits them, despite receiving negative news or signals. 

Let’s imagine, a trader once made a profit when going long on a contract for difference (CFD) on Amazon (AMZN) shares. They now feel confident the price will likely continue rising, leading them to hold onto the position for too long, meaning that when its price trajectory changes there are significant losses.

• Ignoring risk

Overconfidence could lead traders to ignore potential risks associated with an investment. For example, they may ignore the risk associated with a particular sector or industry and trade heavily in it. This could lead to significant losses if the sector or industry experiences a market correction.

• Overtrading

Overconfidence bias could make traders believe that they may make quick profits through frequent trading. They may take more risks than they should and trade too frequently, leading to high transaction costs and lower returns. Overtrading could also lead to a lack of discipline in trading and increased susceptibility to making mistakes.

• Failing to consider alternative viewpoints

Overconfidence bias may be linked to confirmation bias, where people seek out information that supports their beliefs while ignoring information that contradicts them. This could result in traders ignoring or missing important information and making decisions based on incomplete or inaccurate information,potentially leading to losses.

How to counteract overconfidence bias

There are ways people can consider if they want to overcome and counteract overconfidence bias. These could include:

• Acknowledging it. Knowing that overconfidence exists could be the first step in tackling it. 

• Being realistic. Understanding that you do not always make the best decisions all the time could help guard against overconfidence bias.

• Researching the market. Knowing that, very often, markets can do unexpected things could help someone understand the consequences of overconfidence.

• Keeping a note of trades. A trader who records their trades could look over them, see where they went wrong, and gain a sense of perspective that could prevent overconfidence bias.

• Being diligent. Doing their own research and trying to make trades based on facts, rather than emotions, coupled with regularly checking and updating their trading strategies could help stop someone from suffering overconfidence,

Conclusion

A simple overconfidence bias definition is that it is the tendency to overestimate one’s abilities, knowledge, or judgement, that could potentially lead to excessive confidence and risk-taking and result in significant losses. Traders and investors should be aware of the different types of overconfidence and take steps to avoid them, such as seeking out diverse sources of information, avoiding making trades based on emotions, and regularly reassessing their investment strategies.

By doing so, traders could minimise the risk of overconfidence bias and make more informed trading decisions.

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