Behavioral Insights into Investing: Overconfidence Bias

In this episode of My Two Cents, we explore overconfidence bias: the tendency for investors to overestimate what they know, how well they can predict the market, or how skilled they are at picking winners. Listeners will learn how overconfidence can lead to too much trading, too much risk, and too little attention to what could go wrong.

Research mentioned in this episode:

Barber, B. M., & Odean, T. (2000). “Trading Is Hazardous to Your Wealth: The Common Stock Investment Performance of Individual Investors.”
 https://faculty.haas.berkeley.edu/odean/papers/returns/individual_investor_performance_final.pdf

Gao, H., Shi, D., & Zhao, B. (2021). “Does Good Luck Make People Overconfident? Evidence from a Natural Experiment in the Stock Market.”
 https://www.sciencedirect.com/science/article/abs/pii/S0929119921000547

Hoffmann, A. O. I., & Post, T. (2014). “Self-Attribution Bias in Consumer Financial Decision-Making: How Investment Returns Affect Individuals’ Belief in Skill.”
 https://www.sciencedirect.com/science/article/abs/pii/S2214804314000597

Transcript

Intro

SPEAKER_00 0:15

Hey everyone, my name is Mahima Ramachandran, and welcome back to My Two Cents, and to our special series, Behavioral Insights into Investing. Before we begin, a quick note. This series is for educational and awareness purposes only. It is not investing advice, and it is not telling you what to buy, sell, or trade. Our goal is simply to help you understand how our minds work and influence financial decisions.

Overconfidence Bias

SPEAKER_00 0:45

So, with that, let's get into today's bias, overconfidence. Confidence can be very useful. It helps us try new things, ask questions, and start learning about money early. But in investing, confidence can sometimes cross the line. Overconfidence happens when investors like us overestimate their knowledge, their forecasting ability, or their skill at picking stocks and timing the market. It's the voice that says, I know where this stock is going, I can get out before it drops, or I understand this better than everyone else. But investing asks a harder question. At this price, with this risk, does the decision I'm about to make still make sense?

The One-Good-Trade Problem

SPEAKER_00 1:46

Overconfidence can show up after just one good result. Let's say you join a school investing challenge or use a stock simulator. You pick a stock and it goes up 20% in a few weeks. That feeling is amazing, and your brain may start whispering, wait, I actually might be good at this. But one result does not automatically prove a skill. It could be skill, but could also be luck, a rising market, or a risky bet that happened to work just once. There is research on this idea too. A study of investors who received IPO share allotments in China found that after those lucky wins, investors traded more frequently and later actually performed worse compared to others. The effect was especially strong among inexperienced investors.

The Impact of Overconfidence in Trading Behavior

SPEAKER_00 2:45

Overconfidence really shows up in three ways. First, is too much trading. An overconfident investor may think that they can predict short-term price moves so they buy, sell, and jump back in way more often. But every trade is another decision, and every decision creates another chance to be wrong. Behavioral finance researchers studied this for decades. One well-known study by Brad Barber and Terrence Odien looked at tens of thousands of brokerage accounts and found that investors who traded more often generally earned lower net returns after trading costs. Second is too much risk. Investors may put too much money into one company, one sector, or one trend because they're unusually sure of themselves. They'll think, I don't need diversification, I know this one is going to win. And this sounds bold, but it can really be fragile. And the third way overconfidence shows up is not enough attention to the downside. Someone might spend a lot of time explaining why a stock could double, but not focus at all on asking why it could fall.

A History Lesson From the Tech Bubble

SPEAKER_00 4:21

So let's think about like the late nice tech bubble. Technology was changing the world, and the internet was really starting to pick up and become important. But during this run-up, many investors began to believe that almost everything connected to the internet would keep rising. And that is really one of the sneaky parts of overconfidence. When markets go up for a long time, people can confuse a rising market with personal skill. Research on self-attribution bias supports this idea. When investors experience good returns, they may become more convinced of their own investing skill.

Strategies to Combat Overconfidence in Investing

SPEAKER_00 5:40

Can I compare it? First, can I explain it? Before saying, I understand this stock, test that confidence. Can you explain what the company does, how they make their money, what could potentially go right or wrong, why the price might already include a lot of optimism. You do not need to sound like a Wall Street analyst, but you should be able to explain both the opportunity and the risk. The second step, ask yourself, can I track it? Before making a mock investment or a real investment decision, write down what you are choosing, why you are choosing it, what you expect to happen, and how confident you are from a scale of 1 to 10 and what could happen to prove you wrong. Then come back a bit later and check. Did the results match your prediction? Was your confidence level reasonable? And did you miss anything obvious? Checking whether your confidence matches reality. And the third and final step, ask yourself, can I compare it? If your mock portfolio goes up 8%, that sounds good. But what if the overall market went up 12% during the same time? So remember a helpful suggestion. Three steps. Can I explain it? Can I track it? And can I compare it?

Conclusion: Calibrated Confidence in Investing

SPEAKER_00 7:15

So let's bring together everything we talked about today. Overconfidence bias happens when investors like us overestimate their knowledge, their ability to forecast, and their skill at picking stocks and timing the market. It can lead to more trading, higher risk, concentrated positions, and underestimating what could possibly go wrong. The point is really to become a better, more proactive thinker. A good investor does not need to say, I know for sure. But a good investor will say, I have a view, I understand the risks, I know what would change my mind, and I'm willing to check whether I was actually right. That is calibrated confidence. So thank you for listening to my two cents. Until next time, keep learning, keep questioning, and remember sometimes the smartest thing you can say is let me check.