Overconfidence, and why it can sink your returns

In the early hours of 15 April 1912, the ship described as ‘unsinkable’ sunk after it struck an iceberg in the North Atlantic Ocean, killing more than 1500 of the 2224 passengers on board.

The Titanic is a tragic tale of overconfidence. The largest ship afloat at the time, it was said, ‘God himself could not sink this ship’. Despite early warnings, Captain Edward Smith took a route through waters known to have icebergs yet didn’t reduce speed.

It was 11:40pm when the Titanic struck the iceberg. The night was moonless and dark, and visibility was low, yet the ship was still travelling at a speedy 22.5 knots, just shy of its maximum speed of 23 knots.

There were also huge safety lapses, with no one listening to the radio warning messages and no binoculars in the lookout. There were also only enough lifeboats for half the passengers, as it was believed that if tragedy struck, the Titanic would be afloat for long enough for the remaining passengers to be rescued.

The tragedy was a result of many failures, but the underlying cause was overconfidence.

What is overconfidence?

The overconfidence effect occurs when someone’s confidence in their own ability is far greater than what reality would suggest.

The effect causes people to overestimate what they know, what they’re capable of, their chances of success, and their judgements. And it often leads to failure. Surprisingly though, most of us have this bias, yet we don’t realise it.

In one study, it showed that 93% of people believe they are above-average drivers, and in another study, it showed that 84% of Frenchmen believe they are above average lovers. At the University of Nebraska, a survey showed that 68% of teachers rated themselves in the top 25% for teaching ability, with 94% rating themselves above average.

In the investment community, a survey of 300 fund managers found that 74% believed they were above average fund managers, with the remaining 26% believing they were average. Nobody thought they were below average.

Statistically of course, only 50% of people can be above average, so why do people consistently misappraise themselves on the high side?

Why are we overconfident?

One reason is the hindsight bias. This is the belief that we have predicted the past with accuracy, so therefore can predict the future.

Another reason for overconfidence is that our society rewards it. Overconfident people are often viewed as more competent and can attain a higher social status.

Overoptimism can also lead to overconfidence. Sometimes we think we’re going to succeed because of a ‘gut-feel’ yet haven’t really planned properly or calculated the odds of success.

It is well known that optimism and confidence have enormous benefits for individuals and society. Surprisingly though, sometimes overconfidence does too. Daniel Kahneman said, ‘Overconfidence is a curse and a blessing. The people who make great things, were overconfident and optimistic. They take big risks because they underestimate how big the risks are. But there’s a lot of failures’.

Investing

For an investor, overconfidence is never a great quality. It can lead to the investor holding a riskier portfolio, because they think they can predict market action and sidestep any problems. Inevitably, overconfidence leads to underperformance.

Overconfidence can result in speculative bubbles, and also lead to an underappreciation of the complexities of the economic system we work in.

How to overcome overconfidence

There are a number of ways for investors to deal with overconfidence. Here are five:

1. Spend time on the data. Rather than relying on intuition or ‘gut feel’ when choosing an investment, do the analysis and run the numbers to see if the investment is a good one.
2. Consider the consequences of being wrong. Examine the risks and think through what happens if things go wrong.
3. Remember failures. It doesn’t hurt to remind ourselves now and then of past mistakes and the lessons learnt. This has a way of keeping us grounded.
4. Practice predicting. Each month make a prediction of the direction of the market for the upcoming month. At the end of the month check back to see how accurate you were. It should show that the predicting game isn’t easy.
5. Be objective. Confidence and optimism are great qualities but always try to keep them aligned with reality. And always aim to be objective in your decision making.