In this series, we explore some of the most common biases exhibited by investors, and discuss how advisors can help their clients overcome them. This article takes a close look at a powerful cognitive bias: overconfidence bias.

What is overconfidence bias?

Most people tend to overestimate their skills, whether it's changing an electrical outlet or managing their own finances. Consider that some 73% of Americans believe themselves to be better-than average drivers, according to a survey by the American Automobile Association (AAA).¹ Behavioral finance has a name for this ego-driven tendency: overconfidence bias.

In investing, overconfidence bias often leads people to overestimate their understanding of financial markets or specific investments and disregard data and expert advice. This often results in ill-advised attempts to time the market or build concentrations in risky investments they consider a sure thing.

Consider that 64% of investors rate their investment knowledge highly, according to a FINRA study. The research found that younger investors tend to be more confident than older investors. Yet investors with more confidence answered fewer questions correctly on an investment knowledge quiz^.2 

One possible source of overconfidence: the wealth of accessible online information. Studies have found that access to voluminous information can create the illusion of understanding.³ But without sufficient knowledge and context, investors may be ill-equipped to make the most of the information available to them.

Why does it matter?

Overconfidence bias tricks the brain into believing it's possible to consistently beat the market by making risky bets. 

But the evidence shows that even financial experts with powerful tools at their disposal can have difficulty outpacing the market. Case in point: a 2023 Morningstar report found that only a quarter of all active funds beat their passively managed peers over the previous 10-year period.⁴

It should be no surprise that for the average investor, overconfidence can potentially be a pathway to poor portfolio performance. Beyond that, clients’ overconfidence may also lead them to overestimate their tolerance for risk, resulting in investment strategies that don't truly align with their needs. Add to these dangers the high costs of buying and selling assets, and the potential damage of overconfidence on clients’ pocketbooks—and psyches—cannot be underestimated.

What can you do about it?

Overconfidence bias can be countered in a number of ways. One starting point is to encourage clients to make room for the perspective of other people, from family members and friends to your financial team. While we often overestimate our own abilities, we tend to be more objective when considering the decisions of others.

Another strategy is to walk clients through past investment decisions and discuss how they worked out. Demonstrate, if applicable, how overconfidence led to poor outcomes over time, and compare these outcomes with the results the client might have achieved with a more realistic approach.

Finally, consider asking clients to perform a “premortem.” This process, popularized by Nobel Prize–winning economist and psychologist Daniel Kahneman, involves imagining potential outcomes from a future perspective—perhaps 5, 10, or 20 years down the line. Start by imagining that the investment strategy you're considering has succeeded and, from this imagined point in the future, think through all the reasons it has done well. Then imagine that the same strategy has underperformed and think through all the reasons for its failure. This exercise may help people see potential risks and missteps that they might have overlooked in their excessive optimism.

Taking these steps has the potential to help protect clients from making poor investment decisions. And that, in turn, can build a deeper well of trust and strengthen your advisor-client relationship.

Omar Aguilar, Ph.D.
Chief Executive Officer and Chief Investment Officer