Overconfidence
The tendency to have too much confidence in one's knowledge and abilities is called overconfidence, and it is one of the psychological traps we most easily fall into. Let's be clear: having self-confidence is a positive personality trait - it allows us to assert ourselves with others and face life's challenges with a positive attitude, including financial ones; otherwise, no entrepreneur would start a business! However, excessive confidence can lead us to overlook important information, underestimate the risks of certain decisions, and generally behave imprudently.
Why do we fall victim to overconfidence?
According to Nobel laureate Daniel Kahneman, a behavioral economics expert, this may be due to a lack of imagination. We convince ourselves that our idea is correct when we cannot conceive of an alternative or when alternatives are difficult to understand or accept: 'We are blind to the obvious, and we are also blind to our own blindness'.
Researchers have identified two types of overconfidence.
The first type is the above-average effect, which is the tendency to believe we have qualities superior to others. This is an “optimistic bias” that shows poor awareness of the limits of our knowledge and abilities and can therefore cause harm.
I'm better than average!
In a study, Ola Svenson asked some drivers to evaluate themselves in terms of driving skill and caution. The results showed that 93 percent of respondents considered themselves better than average.
When it comes to financial investments, things don't change much: a study by researchers Barber and Odean showed that men interviewed believed they could beat the market and manage their portfolios better than women. Data from the research prove that neither belief is true!
The second type of overconfidence is based on two types of illusion: the illusion of control and the illusion of knowledge. The first refers to the illusion that we can control unpredictable events; the second leads us to believe we have all the necessary information to make the best decisions, even in risky or highly uncertain contexts.
Example 1
Imagine you run a business. Things are going very well, the number of customers is increasing, and you've decided to take out a loan to buy a new store – much larger than your current one – to further boost sales. To determine the loan term and the amount of the installments, you carefully analyze your current income and estimate your future income. You decide on the optimal size for the new store and also figure out how to enrich your product catalogue to attract more customers.
You get the financing from the bank and are finally about to move, but at the last moment, you happen to discover that just two blocks down from your new store, a branch of a large chain operating in your same market sector is about to open. Too bad you didn't take a walk around the corner earlier to see who your competitors would be... What consequences will this have on your business?
Example 2
This time, imagine you want to buy a new car. The base model is very nice, but the price rises considerably if you add all the accessories the dealer has offered you – and you don't want to give any of them up. You do the math and realize that to cover the expense, you'll need to use all your savings. Sure, you still have to pay for your planned vacation, and on top of that, the condo fees will suddenly increase because the elevator needs repairs. Without those savings set aside, it will be tough...
But this year you worked very well, and your boss at the company has repeatedly shown appreciation for the projects you developed. There are other competent and prepared colleagues, but you're sure the raise will go to you. After all, you deserve it. You buy the fully equipped car, but what happens if the promotion goes to a colleague from another office?
The illusion of control and the illusion of knowledge can lead you to believe that the increase in your investment returns is due to your skill in managing them. But what if it doesn't depend on your abilities, or worse, if it's just a completely random circumstance? History is full of unexpected and unpredictable events, sometimes dramatic: for example, on October 19, 1987 – known as Black Monday – the markets worldwide crashed without any warning or rational explanation. The American Dow Jones index lost 22.6 percent, a historic record!
When you invest, be careful about the decisions you make: remember to gather as much information as possible, try to question your own reasoning, and finally, consult with someone more experienced than you. Watch our video to see how overconfidence lurks in your decisions!
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