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  • JULY 13, 2009

Investing: Overconfidence is dangerous

In the previous article on 'availability bias', we discussed how analysts and investors get unduly influenced by their recent experiences in estimating the probability of an event. In this article, we shall examine another tendency called 'overconfidence bias'.

What is 'overconfidence bias'?
We have to exercise our judgment regularly in everyday life. We also have some amount of confidence about the accuracy of our judgment. An important question for investors is: what effect does more information have on our judgment? Also, how does more information affect the level of confidence that we place on our own judgment?

As it turns out, several studies have shown that more information often does not increase the accuracy of our judgment but oddly makes us overconfident about it. In simple words, we tend to get misled by the quantity of information. Ironically, our confidence is particularly misplaced when the chances of our judgment being accurate is 50:50.

The reason for this tendency is easy to understand. Sure footed decision making was critical for the survival of our ancestors. Earlier humans often had to act decisively based on little information in the face of uncertainty. Today, when it comes to stock picking however, the overconfidence bias can lead to irrational behavior.

Examples

  • Trading: The high trading volume witnessed in stock exchanges is based on the overconfidence of market participants. For every trade, there is a buyer and a seller. Both parties express confidence in their own judgment - after all, every trade basically says that my judgment on the price of a stock is superior to yours.

Avoiding the overconfidence bias in stock picking

  • Admit: The first step in dealing with biases is to admit their presence.

  • Quality of information: We should realise that all information is not made equal. For example, the information we derive from reading the investment classics and multiple annual reports is qualitatively superior to other random news bits.

  • Stick to easy picks: Make sure that you stick to areas where your chances of being right are bright. As Warren Buffett says, "Easy does it... we have not learned how to solve difficult business problems. What we have learned is to avoid them... The finding may seem unfair, but in both business and investments it is usually far more profitable to simply stick with the easy and obvious than it is to resolve the difficult."

  • Limit your bets to well researched ones: As Charles Munger, the vice chairman of Berkshire Hathaway says, "Even bright people are going to have limited, really valuable insights in a very competitive world when they're fighting against other very bright, hardworking people... it makes sense to load up on the very few good insights you have instead of pretending to know everything about everything at all times... How many of you have 56 brilliant ideas in which you have equal confidence? How many of you have two or three insights that you have some confidence in?"

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