What is overconfidence bias? How can being overconfident affect your personal finance? How to avoid it?

What is overconfidence bias? How can being overconfident affect your personal finance? How to avoid it? | Vrid
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We are irrational beings – filled with so many biases that it’s hard to take action without being biased. And these biases can cost us a lot in personal finance.

Being bias-free sounds impossible, but being aware of them can help us avoid them to some extent. In our ongoing personal finance bias series, we’ve explored mental accounting bias and loss aversion bias.

In this post, let’s discuss how overconfidence bias can affect your financial well-being.

Estimated read time: 3 minutes and 58 seconds

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Buckle up, here we go!

What is Overconfidence Bias?

Overconfidence bias is a cognitive bias where you tend to overestimate your skills, knowledge, or abilities, leading to poor decision-making. 

This bias can have significant implications on your personal finance. It can lead you to take risks you cannot afford, make poor investments, or cannot plan for the future.

If biased, often you won’t be able to recognise your limitations. You may believe you are more intelligent than others. Maybe that’s why it doesn’t matter if 95% of traders lose their money. People think they are different and can make a profit. 

Overconfidence in investing skills can lead us to believe we can accurately time the market (even though markets are infamously unpredictable).

Did you know people with a high dose of overconfidence were 2.2 times more likely to be financially vulnerable than people with a low level of overconfidence bias?

And a 2020 research paper found that overconfident individual investors rarely manage and control risk properly.

The paper also cites a lot of research that states that men are more overconfident than women, and financial literacy is not related to overconfidence bias.

Other research shows that highly overconfident investors make aggressive and excessive trading compared to low overconfident investors.

Also, there is almost no impact of bad news on the investing behaviour of the overconfident investor, but there is a significant impact of bad news on the investment behaviour of the low overconfident investor.

How does overconfidence bias affect your personal finance?

Overconfidence bias can have a significant impact on your personal finance, especially in investing. Here are some ways that this bias can affect your financial decisions:

1. Trading too frequently: 

If you suffer from overconfidence bias, you may believe you have superior knowledge of the stock market and may trade frequently. This can cause high transaction costs, tax liabilities, and poor investment returns.

2. Insufficient savings: 

You may believe you will always be able to earn a high income and may not have an emergency fund and save enough for the future. This can leave you vulnerable to unexpected expenses, job loss, or other financial shocks.

3. Underestimating risk: 

If you suffer from overconfidence bias, you may underestimate the risks associated with your investments. This can lead you to take on too much risk or invest in unsuitable assets for your financial goals.

4. Impulsive decision-making: 

Overconfidence bias can lead you to make impulsive decisions, such as buying a luxury car or taking an expensive holiday, without considering the long-term financial implications.

How to avoid being biased by overconfidence?

Fortunately, there are some strategies you can use to avoid being biased by overconfidence. They are:

1. Seek feedback: 

One way to avoid overconfidence bias is to seek constant feedback from others. This can help you gain a more accurate perspective on your abilities, knowledge, and decision-making.

2. Educate yourself: 

Educating yourself about personal finance can help to reduce the risks associated with overconfidence bias. Learning about financial concepts can help you make more informed decisions and avoid common pitfalls.

3. Outside view: 

Overconfidence bias causes us to overestimate our abilities. So it is better to take an outside view. Remove yourselves and your skills from the investment decision scenario and rethink everything. This will help you analyse whether you were overconfident.

4. Thinking of the end (premortem): 

While making decisions, think of the end goal and outcome and what will happen if things don’t turn out as expected. What if this went wrong? What if that didn’t go well? Studying every possible detail or last-minute error refines the overconfidence bias behaviour into a critical thinking aspect.

5. Be more systematic: 

While taking investment decisions, be more systematic. Take decisions based on numbers and facts. Don’t rely too much on emotions. Build systems which help you avoid being biased. 

Can overconfidence bias be used to your advantage?

While overconfidence bias can be dangerous to your personal finance, it can also be helpful sometimes.

Sometimes, overconfidence bias can lead you to take risks that result in higher financial rewards. For example, if you take a large position in a stock that you believe will perform well, even though the stock is risky. If the stock does well, you may realise a significant financial gain. 

Similarly, as an overconfident entrepreneur, you may take more risks in starting a business, which can lead to greater financial success if the business is successful.

However, it is crucial to note that these scenarios are the exception rather than the rule. 

In most cases, overconfidence bias leads to poor financial decisions, such as overspending, taking on too much debt, or making risky investments. These decisions can lead to significant financial losses and have a long-term negative impact on your personal finance.

Also, even in cases where overconfidence bias may lead to financial success, it is necessary to consider the potential risks and downsides. That’s because the risks associated with overconfidence bias often outweigh the potential benefits.

Therefore, it is best to avoid being biased with overconfidence. And better to focus on making informed, well-reasoned decisions based on realistic assessments of your financial situation and goals.

Don’t forget to share these insights with your buddies.

Still Curious?

If you are like us, who likes to analyse a little more or check out content in different formats, well you are in luck. Below you can find some suitable content we found.

WallStreetMojo – Overconfidence Bias

The Decision Lab – Why do we overestimate the probability of success?

McCombs School of Business – Overconfidence Bias

Note: We don’t have any affiliation with them. We are sharing links only for educational purposes. The opinions expressed by them belong solely to them and do not reflect the views of Vrid.

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DISCLAIMER: This newsletter is strictly educational and is not an investment advice or a proposal to buy or sell any assets. Please be careful and do your own research.

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