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Managing my investments
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6.3.3 Overconfidence

This illustration shows the silhouette of a man walking a tightrope.
Figure 9 Overconfidence can lead to poor decision-making.

A further factor that may influence the behaviour of individuals in financial situations is overconfidence.

Research into overconfidence in decision making tasks dates back to the 1950s and has a psychological background. Experiments have included asking participants to estimate how many general knowledge questions they will answer correctly in a quiz. Consistently the results demonstrate overconfidence by participants (Lichtenstein et al., 1982). Researchers have also found that people often display a higher level of overconfidence when questions are more difficult.

Research has also been conducted into the estimation people have of their own ability in relation to that of their peers. Evidence of overconfidence in this area has been found here too, with people frequently having an unrealistically positive view of themselves (Taylor and Brown, 1988).

Obernarcher and Osler (2004) looked at the overconfidence levels of over 400 professional currency traders in the US. They found that these traders were overconfident in their own abilities and believed that they were better than other traders that they worked with in the same institution.

The dangers of overconfidence in relation to managing investments seem, on the face of it, fairly obvious and not a trait commonly associated with prudent portfolio management. Theories in overconfidence seem well grounded, but how does overconfidence really play out in financial decisions?

Overconfidence could come into play when estimating the exposure to risk or when considering inputs that are used to make financial decisions. For example, people can be overconfident in the information that they are using to make an investment, not only in the reliability and accuracy of the information, but also in the relevance and impact of that information. In this scenario, investors could be overconfident in the belief that they possess the correct knowledge to make decisions and that there is no other relevant information that they are not party to that may influence prices.

Investors can become overconfident in the potential return that their investment may achieve, and they may also be overconfident in their own ability in managing that investment.