Cognitive Biases - Overconfidence

Behavioral Finance is a relatively new concept. Up until the 1980s-traditional finance was based on several theories that sustained that the market is efficient and systematic. For instance, if following the efficient market hypothesis, given that all investors have access to all available information on a M&A transaction, its impact on the market or the company’s shares should not present any irregularities. However, with the behavioral decision making theories came the following dilemma: what if the investors are not always following a rational decision making process? In 1979, Kahneman and Tversky developed the prospect theory, studying the decision- making process under uncertainty. Behavioral decision making aims to explain irrational thinking on behalf by examining a series of misconceptions that investors are prone to. These biases can easily affect an individual’s perception of gains and losses and lead to decisions which can potentially have significant negative effects.

As such, this paper’s aim is discussing three of the most common biases by attempting to both explain and provide methods for avoiding them.

Overconfidence

Overconfidence is generally explained as people’s tendency to put too much faith in their competences and skills. Interestingly, studies have shown that despite varying in degrees of over-confidence, most individuals display it to a certain extent, making it extremely common. To narrow its study, overconfidence is split in three distinct biases:

1. Over precision

2. Over estimation

3. Over placement

Over precision is an individual’s overconfidence in his belief that he holds the true answer, in the sense that the information he possesses is the most accurate. The most standard form of measurement for it is to request a confidence interval, meaning a range of values between which that person believes the true answer lies. Depending on the size of the range he chose, (the shorter the range of values, the more that person is confident in his answer) you can judge to what extent there is over precision. Results with this method have shown that people do on average tend to have faith in their beliefs that exceeds their accuracy, with overly precise ranges of values. The reason this happens is that giving information more accurate that you are comfortable giving is seen by people as a form of confidence, which leads them to believing that that answer has a higher probability of being correct. Finally, a key characteristic of over precision is its difficulty to de-bias. Indeed, when researching a topic, most people will research arguments that support their opinion far more in depth than arguments that contradict it, thus creating a biased opinion that leads to over precision (Koriat, Lichtenstein, and Fischhoff,