Behavioral Finance

Behavioral Finance
The Role of Psychology

Lecture 3
Overconfidence Bias
5 April, 2015

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General Description.
 The concept of overconfidence derives from a
large body of cognitive psychological experiments
and surveys in which subjects overestimate both
their own predictive abilities and the accuracy of
the information they’ve been given.
 People are poorly rectified in estimating
probabilities—events they think are certain to
happen are often far less than 100 percent
certain to occur.
 In short, people think they are smarter and have
better information than they actually do.
 For example, they may get a tip from a financial
advisor or read something on the Internet, and
then they’re ready to take action, such as making

Technical Description
 Numerous studies have shown that investors are
overconfident
in
their
investing
abilities.
Specifically, the confidence intervals that
investors assign to their investment predictions
are too narrow. This type of overconfidence can
be called prediction overconfidence.
 For example, when estimating the future value of
a stock, overconfident investors will incorporate
far too little flexibility into the range of expected
payoffs, predicting something between a 10
percent gain and decline, while history
demonstrates much more drastic standard
deviations.
 The implication of this behavior is that investors

Technical Description
 Investors are often also too confident of their
judgments. Researchers refer to this type of
overconfidence as certainty overconfidence.
 For example, having determined that a company
is a good investment, people often become blind
to the prospect of a loss and then feel surprised
or disappointed if the investment performs poorly.
 This behavior results in the tendency of investors
to fall victim to a misguided quest to identify the
“next hot stock.”
 Thus, people subject to certainty overconfidence
often trade too much in their accounts and may
hold portfolios that are not diversified enough.

Practical Application
 Roger Clarke and Meir Statman demonstrated a classic
example of prediction overconfidence in 2000 when
they surveyed investors on the following question:
 “In 1896, the Dow Jones Average, which is a price
index that does not include dividend reinvestment,
was at 40. In 1998, it crossed 9,000.
 If dividends had been reinvested, what do you think
the value of the DJIA would be in 1998?
 In addition to that guess, also predict a high and low
range so that you feel 90 percent confident that your
answer is between your high and low guesses.”
 In the survey, few responses reasonably approximated
the potential 1998 value of the Dow, and no one
estimated a correct confidence interval.

Practical Application
 A classic example of investor prediction
overconfidence is the case of the former
executive or family legacy stockholder of a
publicly traded company such as Johnson &
Johnson, ExxonMobile, or DuPont.
 These investors often refuse to diversify their
holdings because they claim “insider knowledge”
of, or emotional attachment to, the company.
 They cannot contextualize these determined
stocks as risky investments.
 However, dozens of once-iconic names in U.S.
business—AT&T, for example have declined or
vanished.

Practical Application of Certainty
Overconfidence
 People display certainty overconfidence in
everyday life situations, and that
overconfidence carries over into the
investment ground.
 People tend to have too much confidence
in the accuracy of their own judgments.
 As people find out more about a situation,
the accuracy of their judgments is not
likely to increase, but their confidence
does increase, as they wrongly associate
the quantity of information with its quality.

Practical Application of Certainty
Overconfidence

 In a relevant study, Baruch Fischoff, Paul
Slovic, and Sarah Lichtenstein gave
subjects a general knowledge test and
then asked them how sure they were of
their answer.
 Subjects reported being 100 percent sure
when they were actually only 70 percent
to 80 percent correct.
 A classic example of certainty
overconfidence occurred during the
technology boom of the late 1990s.
 Many investors simply loaded up on

Research Review

Overconfidence Bias: Behaviors That Can Cause
Investment Mistakes

By
Brad Barber and Terrance Odean

Top
Behavioral
Issues
for
Overconfidence Bias: Behaviors That
Can Cause Investment
FinanceMistakes
1. Overconfident investors overestimate their
ability to evaluate a company as a potential
investment. As a result, they can become blind to
any negative information that might normally
indicate a warning sign that either a stock purchase
should not take place or a stock that was already
purchased should be sold.
2. Overconfident investors can trade extremely as a
result of believing that they have special knowledge
that others don’t have. Excessive trading behavior
has proven to lead to poor returns over time.

Top
Behavioral
Issues
for
Overconfidence Bias: Behaviors That
Can Cause Investment
FinanceMistakes
3. Because they either don’t know, don’t
understand, or don’t care historical investment
performance statistics, overconfident investors can
underestimate their downside risks. As a result, they
can unexpectedly suffer poor portfolio performance.
4. Overconfident investors hold under diversified
portfolios, thereby taking on more risk without a
appropriate change in risk tolerance. Often,
overconfident investors don’t even know that they
are accepting more risk than they would normally
tolerate.

Diagnostic Testing
 This is a diagnostic test for both prediction
overconfidence and certainty Overconfidence.
 If you are an investor, take the test and then
interpret the Results.
 If you are an advisor, ask your client to take these
tests and then discuss the results with you.
 After analyzing the test results, the next Step is
about offer advice on how to overcome the
detrimental effects Of overconfidence.

Prediction Overconfidence Bias Test
Question 1: Give high and low estimates for the
average weight of an adult male whale (the largest
of the toothed whales) in tons. Choose numbers far
enough apart to be 90 percent certain that the true
answer lies somewhere in between.
Question 2: Give high and low estimates for the
distance to the moon in miles. Choose numbers far
enough apart to be 90 percent certain that the true
answer lies somewhere in between.

Prediction Overconfidence Bias Test
Question 3: How easy do you think it was to predict the
collapse of the tech stock bubble in March of 2000?
a. Easy.
b. Somewhat easy.
c. Somewhat difficult.
d. Difficult.
Question 4: From 1926 through 2004, the compound
annual return for equities was 10.4 percent. In any given
year, what returns do you expect on your equity
investments to produce?
a. Below 10.4 percent.
c. Above 10.4 percent.
d. Well above 10.4 percent.

Certainty Overconfidence Bias Test
Question 5: How much control do you believe you
have in picking investments that will beat the market?
a. Absolutely no control.
b. Little if any control.
c. Some control.
d. A fair amount of control.
Question 6: Relative to other drivers on the road,
how good a driver are you?
a. Below average.
b. Average.
c. Above average.
d. Well above average.

Certainty Overconfidence Bias Test
Question 7: Suppose you are asked to read this statement:
“Capetown is the capital of South Africa.” Do you agree or
disagree? Now, how confident are you that you are correct?
a) 100 percent.
b) 80 percent.
c) 60 percent.
d) 40 percent.
e) 20 percent.
Question 8: How would you characterize your personal level
of investment
sophistication?
a. Unsophisticated.
b. Somewhat sophisticated.
c. Sophisticated.
d. Very sophisticated.

Prediction Overconfidence Bias Test
Results Analysis
Question 1: In actuality, the average weight of a
male whale is approximately 40 tons.
Respondents specifying too restrictive a weight
interval (say, “10 to 20 tons”) are likely subject to
prediction overconfidence.
A more comprehensive response (say, “20 to 100
tons”)
is
less
symptomatic
of
prediction
overconfidence.

Prediction Overconfidence Bias Test
Results Analysis
Question 2: The actual distance to the moon is
240,000 miles.
Again, respondents estimating too narrow a range
(say, “100,000 to 200,000 miles”) are likely to be
susceptible to prediction overconfidence.
Respondents naming wider ranges (say, “200,000
to 500,000 miles”) may not be subject to prediction
overconfidence.

Prediction Overconfidence Bias Test
Results Analysis
Question 3: If the respondent recalled that
predicting the separation of the Internet bubble in
March of 2000 seemed easy, then this is likely to
indicate prediction overconfidence.
Respondents describing the collapse as less
predictable are probably less subject to prediction
overconfidence.

Prediction Overconfidence Bias Test
Results Analysis
Question 4: Respondents expecting to significantly
outperform the long term market average are likely
to be subject to prediction overconfidence.
Respondents forecasting returns at or below the
market average are probably less subject to
prediction overconfidence.

Certainty Overconfidence Bias Test
Results Analysis
Question 5: Respondents professing greater
degrees of control over their investments are likely
to be susceptible to certainty overconfidence.
Responses claiming little or no control are less
characteristic of certainty overconfidence.

Certainty Overconfidence Bias Test
Results Analysis
Question 6: The belief that one is an aboveaverage driver correlates positively with certainty
overconfidence susceptibility.
Respondents describing themselves as average or
below-average drivers are less likely to display
certainty overconfidence.

Certainty Overconfidence Bias Test
Results Analysis
Question 7: If the respondent agreed with the
statement and reported a high degree of confidence
in the response, then susceptibility to certainty
overconfidence is likely.
If the respondent disagreed with the statement, and
did so with 50–100 percent confidence, then
susceptibility to certainty overconfidence is less likely.
If respondents agree but with low degrees of
confidence, then they are unlikely to be susceptible to
certainty overconfidence.

Certainty Overconfidence Bias Test
Results Analysis
Question 8: Respondents describing themselves
sophisticated or highly sophisticated investors are
likelier
than
others
to
exhibit
certainty
overconfidence.
If the respondent chose “somewhat sophisticated”
or “unsophisticated,” susceptibility is less likely.

A Final Word on Overconfidence
 One general implication of overconfidence bias in any form
is that overconfident investors may not be well prepared for
the future.
 For example, most parents of children who are high school
aged or younger claim to follow to some kind of long-term
financial plan and thereby express confidence regarding
their long-term financial well-being.
 However, a vast majority of households do not actually
save effectively for educational expenses, and an even
smaller percentage actually own any “real” financial plan
that addresses such basics as investments, budgeting,
insurance, savings and wills.
 This is an warning sign, and these families are likely to feel
unhappy and discouraged when they do not meet their
financial goals.
 Overconfidence can breed this type of behavior and invite
this type of outcome.
