Overconfidence Bias

22 Jun 2023

Causes of overconfidence bias

• In order to define overconfidence bias, it is important to understand some of the causes. These could include:
  
• Doubt avoidance. Very often, people don’t like moments of ambiguity or doubt. Overconfidence could work as a solution, with the overconfident person feeling confident in their abilities to feel sure, even in a situation where they should feel doubtful.
  
• Inconsistency avoidance. A lot of the time, people search for consistency when it comes to new ideas. There is a tendency to search for a link between previously held beliefs and new ones. This may lead people to hold onto their old ideas, even if new evidence contradicts them.
  
• The endowment effect. This phenomenon is where people overvalue things purely because they own them and could feed back into overconfidence.
  
• Hindsight bias. Hindsight bias, the false belief that they saw something happening before it happened when they didn’t could lead to overconfidence.
  
• Incentives. Sometimes, the higher an incentive someone has for doing something, the more determined they are to do it. This could make them believe they have made the right judgments and have the skills to get it done, even when they don’t.
  

Types of overconfidence bias

Overconfidence can come in various forms, including:

• Illusion of control: This type of overconfidence bias refers to the belief that someone has more control over a situation than they do. In trading, it could lead to traders believing they can control the market when they can’t.
  
• Over ranking: This refers to the belief that someone is more talented than they actually are. This is common because no one wants to believe they are below average. In trading, this could lead to traders making trades based on overly optimistic forecasts, culminating in potential losses.
  
• Timing optimism: This is when someone incorrectly thinks they could do work far quicker than they can. This relates to trading when traders believe a trade or investment would pay off far faster than it could.
  
• Desirability effect: Perhaps better known as wishful thinking, this is when someone thinks that something will happen just because they want it to happen.
  

Overconfidence bias examples

• These are some hypothetical cases where trades could go wrong because traders have fallen victim to the overconfidence effect:
  
• Believing an asset’s price will continue moving in the same direction – An example of overconfidence bias in trading is when a trader believes an asset will continue to move in a way that benefits them, despite receiving negative news or signals. Suppose a trader made a profit when going long on a contract for difference (CFD) on Amazon (AMZN) shares. They now feel confident the price will likely continue rising, leading them to hold onto the position for too long, meaning there are significant losses when its price trajectory changes.
  
• Ignoring risk – Overconfidence could lead traders to ignore potential risks associated with an investment. For example, they may miss the risk associated with a particular sector or industry and trade it heavily. This could lead to significant losses if the sector or industry experiences a market correction.
  
• Overtrading
  Overconfidence bias could make traders believe they may make quick profits through frequent trading. They may take more risks than they should and trade too frequently, leading to high transaction costs and lower returns. Overtrading could also lead to a lack of trading discipline and increased susceptibility to making mistakes.
  
• Failing to consider alternative viewpoints
  Overconfidence bias may be linked to confirmation bias, where people seek information supporting their beliefs while ignoring information contradicting them. This could result in traders ignoring or missing important information and making decisions based on incomplete or inaccurate information, potentially leading to losses.
  

How to counteract overconfidence bias

• There are ways people can consider if they want to overcome and counteract overconfidence bias. These could include:
  
• Acknowledging it. Knowing that overconfidence exists could be the first step in tackling it.
  
• Being realistic. Understanding that you do not always make the best decisions all the time could help guard against overconfidence bias.
  
• Researching the market. Knowing that markets can do unexpected things very often could help someone understand the consequences of overconfidence.
  
• Keeping a note of trades. A trader who records their trades could look over them, see where they went wrong, and gain a perspective that could prevent overconfidence bias.
  
• Being diligent. Doing their research and trying to make trades based on facts rather than emotions, coupled with regularly checking and updating their trading strategies, could help stop someone from suffering overconfidence.
  

Conclusion

A simple overconfidence bias definition is the tendency to overestimate one’s abilities, knowledge, or judgement that could lead to excessive confidence and risk-taking and result in significant losses. Traders and investors should be aware of the different types of overconfidence and take steps to avoid them, such as seeking out diverse sources of information, avoiding making trades based on emotions, and regularly reassessing their investment strategies.

By doing so, traders could minimise the risk of overconfidence bias and make more informed trading decisions.