First a quick review: Much of financial theory and how to invest is based upon what the “rational person” would do. Unfortunately, as much as we would like to think so, no one is completely rational. Behavioral finance is the study of irrational situations that people fail to guard against in financial situations.
A third behavioral bias to learn is “overconfidence” bias. This happens when someone has success. They start to think they are omnipotent.
This bias reminds me of high school days when kids win athletic contests. The next day in school you would see many of those kids showing overt cockiness. Although their runaway of success may not have been long, it sure pumped them up.
Unfortunately for most athletes, they eventually meet someone who has better skills and outplays them. This is the downside of the “overconfidence” bias. This is why it is important for everyone to temper the winning celebration, because you never know when you will meet your challenger.
This bias happens a lot in the financial markets. When people pick stocks in a rising market and they continue to rise in a rising market, they feel the confidence that they know what they are doing. This attitude slowly and steadily saturates their ego with greater and greater confidence. At the top of a market, this level of confidence is strong among investors.
When the tide is rising, it is much easier to predict the future of what will happen – everything will rise. This is not to say that some investors aren’t very adept at picking investments, but “a rising tide raises all ships!”
The cycle of overconfidence presents itself clearly in the hedge fund industry. Many hedge funds will be “on top of the world” for a short time followed by a period of decimation. How often do you hear about hedge funds closing and returning the funds back to their investors? It happens a lot! Their investors sell out and move to their next “savior” hedge fund.
There is always some degree of luck in picking investments. The astute investor learns as much as possible about their investment to mitigate the luck factor. The tendency of the overconfident investor is to consider the results of their success as being directly correlated with their skills. This is when bad things can happen.
Nothing is a sure thing, but by being aware of this bias and seconding checking the reasons for your decisions, you may be able to avoid potential errors caused by overconfidence.
Confidence is good. Overconfidence is often disastrous!
