Business & Real Estate

Beware of the perils of overconfidence bias

In 2006, James Montier, a researcher at the investment banking arm of Dresdner Bank, tested the behavioral biases of approximately 300 investment fund managers. One of the questions he asked: “Are you above average at your job?” More than 70% of the respondents answered “yes.” A number even included comments along the lines of, “I know everyone else says they are, but I really am!” Most of the remaining respondents considered themselves average, with only a small fraction reporting themselves as being below average.

The cause of these results is a behavioral bias called overconfidence. It is an egotistical belief that our skills, intelligence or talent is better than it actually is. This is not to be confused with narcissism, a personality disorder in which, according to the Mayo Clinic, a person has an inflated sense of his or her own importance, a deep need for excessive attention and admiration, and a lack of empathy for others. (Does this sound like someone well known in Washington?)

Although overconfidence bias is prevalent throughout all types of businesses, it can be especially problematic when exhibited by financial services professionals. After all, one of the highest-value benefits financial advisers provide is helping clients manage the risks associated with their investment and other financial decisions. Overconfidence can lead us to view those risks as less significant than they actually are.

Another manifestation of overconfidence bias is the illusion of control. In the investment world, this takes the form of forecasting future security prices using some kind of heuristic (for example, technical analysis). The assumption is that the forecaster has knowledge of what controls those prices in the capital markets.

Study after study refutes the ability of anyone to consistently predict anything, let alone security prices, with any statistical significance beyond plain luck. Despite the overwhelming evidence, there is no shortage of pundits in the financial media making predictions right and left as if they know what is going to happen.

Another variant of overconfidence is overestimating the likelihood of a particular outcome occurring simply because it’s the outcome we’d prefer. This is commonly known as wishful thinking, and it is ubiquitous in many ways.

Have you ever resisted selling a mutual fund you were holding at a loss because you wanted to wait for its value to come back to what it was when you bought it? Loss aversion (another financial bias) is what causes you to resist selling it, and wishful thinking is why you expect the fund’s price to increase without any other basis for such an assumption.

In my view, financial advisers should constantly be testing our beliefs and expectations. When making recommendations, we should always consider alternative scenarios and be prepared to recognize when market or economic changes might be invalidating previously held assumptions.

We must be able to recognize our own biases when advising others, or we will find ourselves part of Montier’s 70% while providing advice that is actually well below average.

To read Montier’s paper, visit papers.ssrn.com/sol3/papers.cfm?abstract_id=890563.

Los Altos resident Artie Green is a Certified Financial Planner and principal at Cognizant Wealth Advisors. For more information, email This email address is being protected from spambots. You need JavaScript enabled to view it. or visit cognizantwealth.com.

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