Investment Psychology

Author: (USA) Novosinger
Publisher:
Publish Date: 2007-01-26
Features: People can be overconfident. Psychologists have determined that overconfidence causes people to overestimate their knowledge, underestimate risks, and exaggerate their ability to control events. Does overconfidence occur in investment decision-making? Security selection is a difficult task. It is precisely this type of task in which people exhibit the greatest overconfidence. Are you overconfident?
Question: How good of a driver are you? Compared with the drivers you encounter on the road, are you above average, average, or below average? How did you answer this question? If overconfidence were not involved, approximately one-third of you would answer above average, one-third average, and one-third below average. However, people are overconfident in their abilities. If you are similar to U.S. college students, most feel that they are above average. In one published study, 82% of the sampled college students thought they were above average. Clearly, many of them are mistaken. Many of those students were mistaken because they were overconfident about their skill in driving. Being overconfident in driving may not be a problem that affects your life. However, people are overconfident about their skill in many things. Sometimes overconfidence can affect your financial future.
Consider this financially oriented example. Starting a business is a risky venture. In fact, most new businesses fail. When 2,994 new business owners were asked about their chances of success, they thought they had a 70% chance of success. But only 39% thought that any business like theirs would be as likely to succeed. Why do new business owners think they have nearly twice the chance of success as others? They are overconfident.
Interestingly, people are more overconfident when they feel like they have control of the outcome—even when this is clearly not the case. For example, it is documented that if people are asked to bet on whether a coin toss will result in heads or tails, they tend to overestimate their ability to predict the outcome.