Overconfidence is one of the most damaging psychological biases an investor can have. It leads us to trade too often (racking up unnecessary costs) and too heavily weigh our own analysis (leading to positions that are too large). It is also extraordinarily hard to avoid, and in some ways seems to be humans’ natural state, with studies showing that having an accurate view of one’s abilities is correlated with depression.

In subsequent blogs, we will undoubtedly write more about overconfidence because it is probably the one psychological trait that most correlates with problems. But here we’re going to specifically look at three different types of overconfidence.

In the paper, “Financial Overconfidence Over Time – Foresight, Hindsight, and Insight of Investors,” Christoph Merkle considers three types of overconfidence:

1. Overplacement: Thinking that we are better informed and a better investor than average (maybe we should call this the “I’m head of global macro” bias?)
2. Overprecision: The confidence intervals for our forecasts are too tight.
3. Overestimation: Our historical performance is recalled as better than it actually was.

Using a combination of survey results and trade data for wealthy, self-directed investors he finds:

• The average number of trades each quarter is 11.9.
• The average number of holdings is 15.7.
• They exhibit overplacement in that they expect to beat the market by 2.9% a quarter.
• They exhibit overprecision in that they underestimate market and their portfolio volatility by a factor of four.
• They exhibit overestimation in that they overestimate actual returns by 4.3%.

Think about the implications of those numbers for a minute. These investors churn a poorly diversified portfolio and expect to beat the market by 11.6% a year! From the viewpoint of a dispassionate observer, this is all clearly ludicrous. But, as always, we are terrible at judging our own abilities. This is a very good argument for working in diverse teams where this bias is diluted (although not eliminated as group think will also develop over time).

The study is not without problems. Only 617 clients participated and only 394 completed the full set of surveys. All the participants were customers of the same institution. The study took place during a very volatile period (2008 to 2010). And all behavioral finance studies deserve a degree of skepticism. Nonetheless the results are interesting.

From his study Merkle concludes that:

• Overplacement correlates with high turnover.
• Overprecision and overestimation cause poor diversification because of too few holdings.
• Both cause excessive risk taking.

On the one hand, there is nothing completely new here. But beyond yet more stark evidence of how bad most investors actually are, we think this way of breaking down overconfidence is useful. Anything at all that helps us avoid overconfidence is useful. It is the worst bias an investor can have.

And it makes you insufferable.

Disclaimer

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Except where otherwise indicated, the information contained in this article is based on matters as they exist as of the date of preparation of such material and not as of the date of distribution of any future date. Recipients should not rely on this material in making any future investment decision.