Overconfidence is a well-established cognitive bias. Investors need to understand how overconfidence affects investment decision making. For the investor, overconfidence manifests itself in several different ways.
Overconfidence may lead investors to believe that their past investment returns exceed what they actually achieved. The obvious solution is to perform accurate return calculations. In practice, coming up with meaningful return calculations is much harder than one might think. When return calculations are either inaccurate or non-existent, the overconfident investor fills up the information vacuum with a rosy, distorted view of the past. Overconfidence may lead one to focus on the investments that did well while ignoring the poor performers.
Outside of investments, one can see such overconfidence in the public as a whole: the average American considers himself an above average automobile driver.
Overconfidence may also manifest itself in an unwarranted belief that one has a correct, accurate and truthful understanding of an investment opportunity. Sometimes, the more an investor “knows” about an investment, the more confident the investor becomes in his assessment of the investment’s prospects even if the “information” has little relevance. The investor’s confidence about his ownership of a company soars as he progresses from understanding value and momentum to memorizing its product line, visiting each of its field offices and interviewing sales trainees.
This form of overconfidence can also be seen in the paper industry analyst who gets promoted to portfolio management. Paper stocks are cyclical and not a significant share of the stock market. Therefore, a portfolio manager could ignore them most of the time: if he is wrong and they go up, they are unlikely to move the market so much that the portfolio’s returns will suffer (the same cannot be said for other sectors such as technology or health care). But the former-paper-analyst-turned-portfolio-manager will face constant temptation to own them because he “knows” the paper stocks so well.
One can protect against the dangers of knowing too much about an investment by deciding, in advance, what information best predicts future returns and ignoring all other information.