This is the 15th article in the Behavioral Finance and Macroeconomics series exploring the effect behavior has on markets and the economy as a whole and how advisors who understand this relationship can work more effectively with their clients.
In its most basic form, overconfidence bias can be summarized as unwarranted faith in one's intuitive reasoning, judgment, and cognitive abilities.
Consider the simple example of the drunken driver. Despite an enormous body of evidence illustrating that drinking impairs a person’s ability to drive safely and react quickly, impaired drivers continue to get behind the wheel. If you suggest they shouldn't, the typical responses are, "I'm OK," or "I can handle it," or "I am one of those people who isn't affected by alcohol like other people are." These drinkers are overconfident in their abilities to drive under the influence and assume they can beat the odds.
An investment example of overconfidence bias in action can happen when investors get a tip from a friend, or they read something about an investment on the Internet. Overconfident investors are quickly ready to take action--buying or selling the security in question--based on their perceived knowledge advantage. In reality, the investor should conduct further research and come up with a reasonable basis for making the investment decision. As a result, overconfident investors can trade excessively, because they believe that they possess special knowledge that other investors don't have. And as we know, excessive trading behavior has proven to lead to poor returns over time.
At the macro level, overconfidence can run wild. The late 1990s is probably the best example. This was, of course, the Internet stock boom. Investors indiscriminately poured money into internet businesses that were getting "eyeballs" (page views), rather than looking at the bottom line--whether these companies were making money or not. Millions of dollars were lost investing in overvalued internet companies in those days.
To limit the damage that overconfidence can wreak, I often recommend that my clients establish a "mad money" account. I suggest that clients set aside a small portion of their wealth for "overconfident" trading activities, while leaving the vast majority of their wealth to be managed in a disciplined way. This approach scratches the itch that many investors have to trade their accounts, while at the same time maintaining a prudent, intelligently managed approach with the majority of assets.
Michael M. Pompian, CFA, CAIA, CFP, is the founder and chief investment officer of Sunpointe Investments, an investment advisor to family offices based in St. Louis, Missouri. His book, Behavioral Finance and Wealth Management, is helping thousands of financial advisors globally build better relationships with their clients. Contact Michael at email@example.com.
The author is a freelance contributor to Morningstar.com. The views expressed in this article may or may not reflect the views of Morningstar.