The Confidence Game

Hope, optimism, self-belief—traits that make the world go round. Without these positive qualities, the world would be populated by unimaginative, risk-avoiding pessimists. A sad world with limited innovation and a bleak economic outlook.

On the other end of the continuum lies excessive confidence and optimism, which can be a problem. Overconfidence essentially occurs when we become con artists to ourselves. It is arguably the most important bias identified by behavioral finance, evident when people hold an inflated view of their own competencies and their ability to affect outcomes. This bias leads investors to overestimate their investment skills when facing new decisions with uncertain outcomes and, retrospectively, inflates the value of past successes.

Overconfidence has direct implications when it comes to investment decision-making, which is largely based on making forecasts about an uncertain future. Individuals with unrealistic expectations frequently underestimate risks. In the aggregate, overconfident investor behavior leads to market bubbles due to a focus on aggressively chasing returns.

So how can we tame overconfidence? Unfortunately, simply deciding to become more of a realist is easier said than done. What’s needed as a different approach to evaluating and making decisions.

One important way in which overconfidence can be reduced is to encourage people to consider factors outside of their control. This can be done by making those factors more salient in the way the decision is presented or providing illustrative examples of outcomes that could not be predicted or influenced.

James Montier, who has written extensively about behavioral finance, suggests that the problem of excessive optimism can be tackled by asking yourself a different default question. Instead of asking “Can I believe this?” ask yourself “Must I believe this?”.

Indeed, this approach reflects one of several ways of debiasing decisions more generally, such as:

  • Consider-the-opposite. A devil’s advocate approach encourages decision makers to look for reasons why their judgment may be wrong (rather than right). It directs attention to contrary evidence that would otherwise not be considered.
  • Getting more information. Many biases are the result limits in information quantity or quality. Overconfident people are likely to choose and interpret information selectively. Having more complete and diverse information works to the decision makers advantage.
  • Accountability. A person who is made to justify his or her choices is more likely to engage a critical and reflective mindset in decision-making.
  • Asking others. Individuals who incorporate other people’s perspectives, experience or knowledge in their decisions are less likely to exclusively rely on their own biased judgment.
  • Cooling off. Imposing or self-imposing a cooling off period prior to a decision can counteract impulsive actions. This approach may also work for ‘hot’ types of biases that have a motivational component, such as the wishful thinking or self-enhancement aspects of overconfidence.
  • Feedback. Lack of information about the outcomes of past actions is a decision makers worst enemy, because it limits the ability to learn from mistakes. The more timely the feedback, the more effective it generally is.

While these debiasing techniques are directly applied to decisions at hand, there are also more extensive solutions, particularly training people in the fields of logic, statistics, or economics. Individuals with a better understanding of statistics, for example, are more likely to appreciate randomness and critically examine the quality of the evidence at hand.

The critical thinking aspect of education is an effective treatment for bias and becomes even more powerful if it involves introspection. This is particularly pertinent to overoptimism, which is in part a matter of impaired self-criticism. One way to foster this quality is to simply educate people directly about biases and how these may affect their own decision-making.

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