Overconfidence bias seriously affects your investment decisions and undermines financial goals

Investors, including professional portfolio managers, are prone to cognitive and emotional biases. Overconfidence bias is one of the most common and harmful biases, leading to overestimating one's abilities, making overly precise forecasts, ignoring relevant information, and trading too frequently with poor diversification, resulting in poor long-term performance. You can discover whether you are prone to overconfidence bias and the extent to which it affects your investment decisions with PRAAMS BehaviouRisk.

Behavioural economics. What is overconfidence bias?

It is the psychological tendency for a person to overestimate his own abilities. Overconfidence bias is one of the most common and harmful biases, and exacerbating matters, a person with this bias often finds it difficult to recognise and admit to it. 

What are the consequences and investment risks? 

In asset allocation, overconfidence bias prompts investors to make and rely on overly precise forecasts, leading to consistent underestimation of risk factors. It also results in investors being too assured in their judgements and likely to ignore further relevant information about the investment. Typically, a person with a solid overconfidence bias trades too frequently and has poor diversification. The latter lead to poor long-term performance for individual investors, impairing investment objectives, as proven by many studies (e.g., Trinugroho and Sembel’s 2011 study and review). An overconfident person is quick to make investment decisions based on incomplete information, which he assumes equips him with an information advantage. He is also likely to tenaciously hold the investment until the market proves his trade idea seriously wrong.

What can I do to make my portfolio more efficient?

First, carefully and frankly analyse how overconfidence behavioural bias displays itself in your decision-making and risk-management strategies. This bias is dangerous because one does not readily acknowledge it. Assuming you believe that you have an excellent investment-picking ability, we suggest you compare your portfolio's returns to a benchmark like the S&P 500 index or several broad-based funds for several years. Studies suggest your performance may lag the market. In the financial markets, you are trading against institutions with armies of research professionals, risk analysts and traders with high-speed computers that have better access to relevant information and can process it faster than you.

The same advice is valid if you trade excessively. If your annual portfolio turnover exceeds 20% (more than one-fifth of your portfolio is reinvested each year), it is worth taking notes on each trade for several quarters and examining the respective returns. Benchmarking against a broad index or a fund can be very illustrative.

Next, record your reasoning for investing in a particular asset. Try to be as frank as possible; ultimately, you are investing your money, and no one can help you better than yourself. A typical sign of overconfidence bias is that even an insignificant amount of information from a widely available source may motivate you to trade. Our experience shows that providing an investor with an independent second opinion on the return and risk relationship in terms of numbers can help immensely to re-evaluate the trade.

Finally, it is wise to pay attention to diversification in your portfolio management approach. If your portfolio includes less than twenty investments or the share of any of them exceeds 5%, it is a red flag for insufficient diversification. Ask yourself this question: “If I didn’t have asset X yesterday, would I buy this amount today?”. Often the answer is ‘no’, which means that over time overconfidence pushed you to grow your position in X above what you consider appropriate. Diversification is not only about percentages in your portfolio; proper diversification is also about avoiding concentrations in regions, countries, industries, and other common risk factors. To properly analyse the degree of portfolio diversification, you will likely need the help of a professional financial risk manager.