Heuristic-driven biases: 2. Overconfidence

2. Overconfidence

People tend to be overconfident and hence overestimate the accuracy of their forecasts. Overconfidence stems partly from the illusion of knowledge.

The human mind is perhaps designed to extract as much information as possible from what is available, but may not be aware that the available information is not adequate to develop an accurate forecast in uncertain situations.

Overconfidence is particularly seductive when people have special information or experience - no matter how insignificant - that persuades them to think that they have an investment edge. In reality, however, most of the so called sophisticated and knowledgeable investors do not outperform the market consistently.

Another factor contributing to overconfidence is the illusion of control. People tend to believe that they have influence over future outcomes in an uncertain environment. such an illusion may be fostered by factors like active involvement and positive early outcomes. Active involvement in a task like online investing gives investors a sense of control. Positive early outcomes, although they may be purely fortuitous, create a illusion of control.

Is overconfidence not likely to get corrected in the wake of failures? It does not happen as much as it should. Why?

People perhaps remain overconfident, despite failures, because they remember their successes and forget their failures.

Harvard psychologist Langer describes this phenomenon as "head I win, tail it's chance". Referred to as self-attribution bias, it means that people tend to ascribe their success to their skill and their failure to bad luck. Another reason for persistent overconfidence and optimism is the human tendency to focus on future plans rather than on past experience.

Overconfidence manifests itself in excessive trading in financial markets. It also explains the dominance of active portfolio management, despite the disappointing performance of many actively managed funds.