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Overconfidence is a prevalent bias in the market. It is often observed during big bull runs like the one we are in now. But what does it mean, and how can investors overcome it? Dr Ryan Murphy, head of the Behavioural Insights Group at Morningstar, explains that on a podcast with Behavioural Finance Exchange.
Here are some excerpts from the podcast.
What is overconfidence bias?
Simply put, it is the tendency for a person to overestimate their knowledge and abilities about something. Murphy describes this as "a phenomenon where people's confidence level outruns their accuracy level".
He also believes that overconfidence bias does not happen on its own. In fact, it stems from various other biases, such as inattentional blindness, confirmation bias, availability bias, and hindsight bias. He delved into each bias and how to overcome them in the podcast. Here's what he said in brief.
Inattentional blindness
Murphy mentions, "Part of it (overconfidence) is fueled by this inattentional awareness, not knowing what we don't know. And I think that's very hard to try, and there's no magic wand where you can teach people just to be aware of everything."
How to overcome it?
Murphy advises investors to get into the habit of pausing and thinking about what they might be overlooking. He also urges investors to revisit past instances where their unawareness had led to losses. He says, "I think that helping people be a little bit accustomed to starting to look further than they see at the moment...I think that momentary reflection might help reduce inattentional blindness".
Confirmation bias
Murphy explains confirmation bias as "people's tendency to look for evidence that already supports their existing conclusions".
How to overcome it?
He describes its solution as exploring both the yin and yang of every decision. He says,"Basic things like reminding yourself that in markets for every trade, there's two sides of it...trying to imagine yourself in someone else's shoes can help reduce the effects of confirmation bias".
Availability heuristic and hindsight bias
Murphy says that availability heuristic "is a psychological phenomenon and relates to memory." He says that "things that are easy to remember have a bigger effect on our judgement" and hence fuel overconfidence. He further describes it by saying, "So the way our memories work, the things that are easiest to recall can have a big impact, and what's easy to remember is not always necessarily reflective of how the world actually operates".
Murphy defines hindsight bias as the inclination of individuals to reflect on past events and believe that the correct decision was apparent, thinking that if they were in that situation, they would have chosen correctly.
He gives an example of TV experts who "are able to explain things after they've happened, but they have almost no capacity to predict things before they happen." This kind of thinking leads to false confidence in their ability.
How to overcome it?
According to Murphy, "Availability and hindsight, I think both of these can be reduced by keeping good records, by quantifying and being very precise in the kinds of forecasts and predictions we make, writing them down and having them recorded such that we can go back later and score them to find out."
An uncomfortable reality
A harsh thing about overcoming overconfidence is how uncomfortable it can be for a person as a process. Murphy says, "Doubt is an uncomfortable state of the world. Our brains sometimes don't like that and seek black-or-white solutions. And sometimes, things just aren't that simple. So I think that one thing we can do for each other as we work in teams is to recognise these kinds of limitations we have and find ways to support this. And it's okay to disagree, and it's okay to be unsure, and it's okay to be wrong."
The above are the most rewarding bits from the podcast. However, we urge our readers to listen to the entire conversation. Click here for the full podcast.
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