What Is Overconfidence Bias In Investing?

You want to make confident decisions when you invest. Confidence, however, isn’t the same as overconfidence. When you have too much confidence, you put yourself in a position to believe things without sufficient evidence.

Like many cognitive biases, overconfidence can hurt your approach to investing. Learning more about overconfidence bias may very well help you to make better decisions and reap more rewards from your investment strategy.

Let’s take a closer look at overconfidence bias and how it could influence your investment decisions.

What Is Overconfidence Bias?

You can find examples of overconfidence bias in all areas of life. For example, the majority of people believe they have above-average intelligence. Similarly, over 90% of American drivers think they can operate their vehicles better than the median person.

Both of these beliefs are statistically impossible. While most people might think they’re in the 90th percentile of drivers, only about 49% can be above average. That’s simply how the math works.

Imagine a classroom of 100 students. If 90% of them said they were in the top 10% of the class, you would know most of them had an overconfidence bias. After the teacher averaged their scores, you would see that 10 students were in the top 10%. That means about 80% of the students believed they were performing better than they were in reality.

How Overconfidence Bias Can Hurt Your Investment Strategy

Overconfidence bias can encourage you to take on exceptional risk or — just as harmfully — miss opportunities to increase your returns.

There are slightly different types of overconfidence bias, so it can hurt your investment strategy in different ways.

Let’s say you firmly believe you can predict market fluctuations. You have so much faith in your abilities that you buy and sell shares erratically to stay ahead of other traders. You believe this approach will earn you wealth, but it puts you at risk of buying shares in overrated companies, racking up transaction costs, and selling shares in solid companies before their prices increase.

Overconfidence bias could also encourage you to take excessive risk. You might concentrate all of your investing funds in one sector, or you might spend a large amount of money on a stock you believe will beat the odds.

When you believe you can predict the market’s behavior, you set yourself up for disappointment. At the time, though, making risky moves seems like the right thing to do because you don’t stop to question yourself.

How You Can Avoid Overconfidence Bias When Investing

Clearly, you want to avoid overconfidence bias in investing. Tempering your confidence can be difficult, though, especially when bucking trends in the past has helped you make money. Eventually, overconfidence bias will almost certainly catch up with you. Use the following strategies so you can minimize the negative effects overconfidence can have on your investment portfolio.

Set Realistic Expectations and Track Returns

In its extreme form, overconfidence bias can convince investors that they know more than anyone, including experts who track markets for a living. You might believe you have insights that will make your portfolio more effective than possible.

This form of overconfidence bias isn’t that different from a student who believes they can write a difficult term paper in one night. The student has deluded themself into believing they can do a superhuman amount of work in a short amount of time. Similarly, you might think you can build an unrealistically profitable portfolio that defies the odds.

To help counter overconfidence, set realistic expectations for your investments. More likely than not, you’ll want to take a long-term perspective to grow worth over time. Very, very few people get rich quickly.

Also, track the amount of money you invest and the returns you get. You’ll probably have a mixture of successful and unsuccessful investments in your portfolio. Seeing those numbers is a great way to check your ego and remember that everyone makes mistakes. Not even the “Oracle of Omaha” makes the right choice every time.

Explore Diverse Opinions Before Investing

Individual investors aren’t the only people who fall for overconfidence bias. Professional stock analysts can become overly confident, too.

Exploring a lot of different opinions creates opportunities for you to question your beliefs. After enough research, you’ll probably start noticing that some professionals believe their own research more than they should.

All of this information is helpful because it checks your assumptions and leads you to level-headed analysts with enough experience to know they make mistakes. A humble opinion isn’t a wrong opinion. Often, it means that the analyst understands that many factors influence how markets evolve. They can only look at the available evidence, make rational choices, and hope their insights bear fruit.

Most importantly, you need to see that equally talented analysts can reach different conclusions from the same data. If they don’t have perfect track records, you can’t expect yourself to have one. It’s an essential lesson in humility.

Diversify Your Portfolio for Long-Term Success

With or without overconfidence bias, you will make some bad investment decisions in your lifetime.

Diversify your portfolio so you can minimize risk in your investments. For example, you might buy shares of companies in different sectors, such as information technology, healthcare, communication services, and consumer staples. At some point, one of these sectors will probably fall behind your expectations. That’s not a huge problem as long as you have other investments to balance out those losses.

It also makes sense to choose assets you believe will lead to long-term success. Yes, some people manage to make money by buying and selling shares quickly. It doesn’t work for many investors, though. Plus, the wealthiest investors — people like Buffett and Soros — preach the wisdom of buying shares in solid companies and holding those investments while the companies grow.

When you tend to hold shares, you lower the number of times you interfere with your portfolio. That means you create fewer opportunities for overconfidence bias to distort your strategy.

Overconfidence bias is powerful, but you can’t let it guide your investments. Accept that you will probably fail on occasion even as you focus on building a portfolio that gets excellent long-term results.

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The author has no position in any of the stocks mentioned. Financhill has a disclosure policy. This post may contain affiliate links or links from our sponsors.