Bias 18: Overconfidence

Are you overconfident? Let’s take this small test to get an answer!

Please answer each question and indicated how confident you are in your answer.

Which city has more inhabitants?

  1. Paris
  2. Rio de janeiro
  3. Chennai

Confidence degree: 10% 30% 50% 70% 100%

Which the capital of Ouzbekistan?

  1. Tashkent
  2. Tshakent
  3. Tshekant

Confidence degree: 10% 30% 50% 70% 100%

What is the first cause of death in the US?

  1. Cancer
  2. Car accident
  3. Heart disease

Confidence degree: 10% 30% 50% 70% 100%

What is the name of the first son of Catherine de’ Medici?

  1. Henri II
  2. Francis II
  3. Charles IX

Confidence degree: 10% 30% 50% 70% 100%

Overconfidence encompasses different manners of overestimating one’s capabilities. For instance:

  1. Better-than-average effect: to think that we are better than the average of the others
  2. Overoptimism: to think that our capabilities and knowledge will be necessarily better in the future
  3. Better-than-reality effect: to think that our capabilities are better than they are in reality

This bias has been shown to have a particularly strong impact on business decisions. The most traditional way to measure overconfidence bias in the academic world is to take a test similar to above, with more questions. The lower their score is, the more overconfident they are.

There are many other ways to measure overconfidence:

(1) EMPIRICAL APPROACH:
Analysis of the speech or past behaviors of traders by comparison with reality (Tate, Malmendier,2005)

(2) COGNITIVE TESTS:

  1. COMPARISON WITH THE AVERAGE: Subjects can be requested to evaluate their own confidence in a statement. All the statements with a given level of confidence can be grouped together and be compared to the actual frequency of being correct.
  2. COMPARISON WITH INDIVIDUAL ACTUAL RESULTS: Subjects can be tested with multiple-choice questions and their level of confidence (sometimes in the form of intervals) in their answer can be elicited on a scale from chance to total certainty by comparing this to the true accuracy of their answers.
  3. BETTING TASK: Subjects can be given the opportunity to bet on the correctness of their answers with chances that are favourable, if their judgements of accuracy are correct, which means that they lose money if they are overconfident.

These different methods have been used in management to study, for instance, how entrepreneurs are overconfident by comparison with managers or financial professionals. Here are some results of these studies.

Entrepreneurs are more overconfident than managers

An experiment conducted by Busenitz and Barney in 1997 has shown that entrepreneurs were more overconfident than managers.

Overconfident people are more narcissistic and risk-takers

In another experiment completed by Campbell and al., narcissistic people (with a high self-esteem) are shown to be more of a risk-taker and overconfident. Several studies conducted on traders confirm this strong correlation between overconfidence and risk-taking behaviors.

Overconfidence increases trading volume and market depth without increasing the expected utility of overconfident traders

Studied by T.Odean and Weber and al., overconfident traders are shown to be less effective than the other traders by trading more and taking more risk without increasing profitability.

Overconfidence
Glaser, Markus, and Martin Weber. “Overconfidence and trading volume.” The Geneva Risk and Insurance Review 32.1 (2007): 1-36

Some other consequences of overconfidence on financial decisions:

  1. Aggressive trade (e.g. Deaves et al., 2009)
  2. Portfolio undiversification (e.g. Odean, 1999)
  3. Pursuit of the active portfolio strategy (e.g. De Bondt and Thaler,1994)
  4. Suboptimal performance (e.g. Fenton-O’Creevy et al., 2003).

Reference:

Volume, volatility, price, and profit when all traders are above average, T.Odean, 1998
Glaser, Markus, and Martin Weber. “Overconfidence and trading volume.” The Geneva Risk and Insurance Review 32.1 (2007): 1-36

Differences between entrepreneurs and managers in large organizations: Biases and heurisitcs in strategic decisino-making, Journal of Business Venturing (1997) Volume: 12, Issue: 1, Publisher: Elsevier, Pages: 9-30

Narcissism, Confidence, and Risk Attitude, W. KEITH CAMPBELL*, ADAM S. GOODIE and JOSHUA D. FOSTER