001 Cognitive Bias: Overconfidence

Notes from Think Like the Great Investors by Colin Nicholson:

Studies have shown that we are more likely to be confident when we try to estimate something when that thing is difficult to estimate than when it is comparatively easy. An example of this is the fair value of a stock. The reason for this is because our brains simplify the task by focussing only on one or two things and not taking account of the many factors which drive a share’s price.

We tend to be overconfident when the confidence of the general community is high, such as at the peak of a bull market. One way you know that you are at the peak of a bull market is that it’s hard to find someone who isn’t bullish, or when those who aren’t bullish are ridiculed or ignored.

Lack of expertise – Students leaving an exam centre were asked to predict their results. Those who said they didn’t study (and therefore scored badly) expected higher grades than they were actually awarded. Those who said they studied did better at predicting what their final score would be.

Hubris – Those who become experts in a particular field quickly get used to the situation where the people they mostly deal with don’t know as much as them. This causes them to become arrogant about their abilities, not only in their field of expertise, but in other areas in general.

Confirmation bias – Humans tend to seek out information that supports their decisions and ignore that which doesn’t. If you can’t find any reasons against an investment decision then you haven’t searched hard enough to find them. The best decisions are usually the ones you have agonised over the most to get right. There is little profit in easy decisions that are obvious to all.

Selective memory – It is more pleasant to remember and talk about our successes than our failures. So we develop an unbalanced view of how good an investor we are. This reinforces our feelings of superiority and hubris. Keeping good records can help with this.

The notion that more information is better is an illusion. What helps us is not how much information we have but identifying which of it is useful and valid.

Availability bias – We most strongly recall and are influenced by those situations which:

  • happened to us personally or to people close to us;
  • are very shocking; and
  • happened most recently.

These influences lead to poor judgement because of:

  • small sample size;
  • lack of proportion; and
  • we are blinded to what the true probability is.

Some strategies to overcome overconfidence:

  • Seek out contrary views.
  • Concentrate on the critical information, not all the information.
  • Focus on a few stocks rather than many.
  • Keep good records and an investment journal listing reasons why you bought and why you sold and any lessons.
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