Behavioral Finance

The Role of Psychology

Lecture 3
Overconfidence Bias
5 April, 2015
.
General Description.
The concept of overconfidence derives from a large body of
cognitive psychological experiments and surveys in which
subjects overestimate both their own predictive abilities and
the accuracy of the information theyve been given.
People are poorly rectified in estimating probabilitiesevents
they think are certain to happen are often far less than 100
percent certain to occur.
In short, people think they are smarter and have better
information than they actually do.
For example, they may get a tip from a financial advisor or
read something on the Internet, and then theyre ready to
take action, such as making an investment decision, based on
their perceived knowledge advantage.
Technical Description
Numerous studies have shown that investors are
overconfident in their investing abilities. Specifically, the
confidence intervals that investors assign to their investment
predictions are too narrow. This type of overconfidence can
be called prediction overconfidence.
For example, when estimating the future value of a stock,
overconfident investors will incorporate far too little flexibility
into the range of expected payoffs, predicting something
between a 10 percent gain and decline, while history
demonstrates much more drastic standard deviations.
The implication of this behavior is that investors may
underestimate the downside risks to their portfolios.
Technical Description
Investors are often also too confident of their judgments.
Researchers refer to this type of overconfidence as certainty
overconfidence.
For example, having determined that a company is a good
investment, people often become blind to the prospect of a
loss and then feel surprised or disappointed if the investment
performs poorly.
This behavior results in the tendency of investors to fall victim
to a misguided quest to identify the next hot stock.
Thus, people subject to certainty overconfidence often trade
too much in their accounts and may hold portfolios that are
not diversified enough.
Practical Application
Roger Clarke and Meir Statman demonstrated a classic example of
prediction overconfidence in 2000 when they surveyed investors on
the following question:
In 1896, the Dow Jones Average, which is a price index that does
not include dividend reinvestment, was at 40. In 1998, it crossed
9,000.
If dividends had been reinvested, what do you think the value of
the DJIA would be in 1998?
In addition to that guess, also predict a high and low range so that
you feel 90 percent confident that your answer is between your
high and low guesses.
In the survey, few responses reasonably approximated the potential
1998 value of the Dow, and no one estimated a correct confidence
interval.
Practical Application
A classic example of investor prediction overconfidence is the
case of the former executive or family legacy stockholder of a
publicly traded company such as Johnson & Johnson,
ExxonMobile, or DuPont.
These investors often refuse to diversify their holdings
because they claim insider knowledge of, or emotional
attachment to, the company.
They cannot contextualize these determined stocks as risky
investments.
However, dozens of once-iconic names in U.S. business
AT&T, for example have declined or vanished.
Practical Application of Certainty Overconfidence

People display certainty overconfidence in everyday

life situations, and that overconfidence carries over
into the investment ground.
People tend to have too much confidence in the
accuracy of their own judgments.
As people find out more about a situation, the
accuracy of their judgments is not likely to increase,
but their confidence does increase, as they wrongly
associate the quantity of information with its quality.
Practical Application of Certainty Overconfidence

In a relevant study, Baruch Fischoff, Paul Slovic, and

Sarah Lichtenstein gave subjects a general knowledge
test and then asked them how sure they were of
their answer.
Subjects reported being 100 percent sure when they
were actually only 70 percent to 80 percent correct.
A classic example of certainty overconfidence
occurred during the technology boom of the late
1990s.
Many investors simply loaded up on technology
stocks, holding highly concentrated positions, only to
see these gains vanish during the meltdown.
 Research Review

Overconfidence Bias: Behaviors That Can Cause

Investment Mistakes

By

Brad Barber and Terrance Odean

Overconfidence Bias: Behaviors
Top Behavioral ThatFinance
Issues for Can Cause
Investment Mistakes
1. Overconfident investors overestimate their ability to
evaluate a company as a potential investment. As a
result, they can become blind to any negative
information that might normally indicate a warning sign
that either a stock purchase should not take place or a
stock that was already purchased should be sold.
2. Overconfident investors can trade extremely as a
result of believing that they have special knowledge
that others dont have. Excessive trading behavior has
proven to lead to poor returns over time.
Overconfidence Bias: Behaviors
Top Behavioral ThatFinance
Issues for Can Cause
Investment Mistakes
3. Because they either dont know, dont understand,
or dont care historical investment performance
statistics, overconfident investors can underestimate
their downside risks. As a result, they can unexpectedly
suffer poor portfolio performance.
4. Overconfident investors hold under diversified
portfolios, thereby taking on more risk without a
appropriate change in risk tolerance. Often,
overconfident investors dont even know that they are
accepting more risk than they would normally tolerate.
Diagnostic Testing
This is a diagnostic test for both prediction overconfidence
and certainty Overconfidence.
If you are an investor, take the test and then interpret the
Results.
If you are an advisor, ask your client to take these tests and
then discuss the results with you.
After analyzing the test results, the next Step is about offer
advice on how to overcome the detrimental effects Of
overconfidence.
Prediction Overconfidence Bias Test

Question 1: Give high and low estimates for the average weight
of an adult male whale (the largest of the toothed whales) in
tons. Choose numbers far enough apart to be 90 percent certain
that the true answer lies somewhere in between.

Question 2: Give high and low estimates for the distance to the
moon in miles. Choose numbers far enough apart to be 90
percent certain that the true answer lies somewhere in between.
Prediction Overconfidence Bias Test
Question 3: How easy do you think it was to predict the collapse of the
tech stock bubble in March of 2000?
a. Easy.
b. Somewhat easy.
c. Somewhat difficult.
d. Difficult.
Question 4: From 1926 through 2004, the compound annual return for
equities was 10.4 percent. In any given year, what returns do you
expect on your equity investments to produce?
a. Below 10.4 percent.
c. Above 10.4 percent.
d. Well above 10.4 percent.
Certainty Overconfidence Bias Test
Question 5: How much control do you believe you have in
picking investments that will beat the market?
a. Absolutely no control.
b. Little if any control.
c. Some control.
d. A fair amount of control.
Question 6: Relative to other drivers on the road, how good a
driver are you?
a. Below average.
b. Average.
c. Above average.
d. Well above average.
Certainty Overconfidence Bias Test
Question 7: Suppose you are asked to read this statement: Capetown is the
capital of South Africa. Do you agree or disagree? Now, how confident are
you that you are correct?
a) 100 percent.
b) 80 percent.
c) 60 percent.
d) 40 percent.
e) 20 percent.
Question 8: How would you characterize your personal level of investment
sophistication?
a. Unsophisticated.
b. Somewhat sophisticated.
c. Sophisticated.
d. Very sophisticated.
Prediction Overconfidence Bias Test Results Analysis

Question 1: In actuality, the average weight of a male whale is

approximately 40 tons.

Respondents specifying too restrictive a weight interval (say, 10

to 20 tons) are likely subject to prediction overconfidence.

A more comprehensive response (say, 20 to 100 tons) is less

symptomatic of prediction overconfidence.
Prediction Overconfidence Bias Test Results Analysis

Question 2: The actual distance to the moon is 240,000 miles.

Again, respondents estimating too narrow a range (say, 100,000

to 200,000 miles) are likely to be susceptible to prediction
overconfidence.

Respondents naming wider ranges (say, 200,000 to 500,000

miles) may not be subject to prediction overconfidence.
Prediction Overconfidence Bias Test Results Analysis

Question 3: If the respondent recalled that predicting the

separation of the Internet bubble in March of 2000 seemed easy,
then this is likely to indicate prediction overconfidence.

Respondents describing the collapse as less predictable are

probably less subject to prediction overconfidence.
Prediction Overconfidence Bias Test Results Analysis

Question 4: Respondents expecting to significantly outperform

the long term market average are likely to be subject to
prediction overconfidence.

Respondents forecasting returns at or below the market average

are probably less subject to prediction overconfidence.
Certainty Overconfidence Bias Test Results Analysis

Question 5: Respondents professing greater degrees of control

over their investments are likely to be susceptible to certainty
overconfidence.

Responses claiming little or no control are less characteristic of

certainty overconfidence.
Certainty Overconfidence Bias Test Results Analysis

Question 6: The belief that one is an above-average driver

correlates positively with certainty overconfidence susceptibility.

Respondents describing themselves as average or below-average

drivers are less likely to display certainty overconfidence.
Certainty Overconfidence Bias Test Results Analysis

Question 7: If the respondent agreed with the statement and

reported a high degree of confidence in the response, then
susceptibility to certainty overconfidence is likely.

If the respondent disagreed with the statement, and did so with

50100 percent confidence, then susceptibility to certainty
overconfidence is less likely.

If respondents agree but with low degrees of confidence, then

they are unlikely to be susceptible to certainty overconfidence.
Certainty Overconfidence Bias Test Results Analysis

Question 8: Respondents describing themselves sophisticated or

highly sophisticated investors are likelier than others to exhibit
certainty overconfidence.

If the respondent chose somewhat sophisticated or

unsophisticated, susceptibility is less likely.
A Final Word on Overconfidence
One general implication of overconfidence bias in any form is that
overconfident investors may not be well prepared for the future.
For example, most parents of children who are high school aged or
younger claim to follow to some kind of long-term financial plan and
thereby express confidence regarding their long-term financial well-being.
However, a vast majority of households do not actually save effectively for
educational expenses, and an even smaller percentage actually own any
real financial plan that addresses such basics as investments, budgeting,
insurance, savings and wills.
This is an warning sign, and these families are likely to feel unhappy and
discouraged when they do not meet their financial goals.
Overconfidence can breed this type of behavior and invite this type of
outcome.
Investors need to guard against overconfidence and financial advisors
need to be in tune with the problem.
Recognizing & limiting overconfidence is a key step in establishing the
basics of a real financial plan.