For years, economists have warned investors about the costs of having too much faith in their own ability. It can lead to excessive trading; to taking on too much risk; and to buying expensive stocks or funds.
However, Thomas Eisenbach at the New York Fed and Martin Schmalz at the University of Michigan show that there can be an upside to overconfidence.
This, they say, is because we often have time-inconsistent risk preferences. We might believe now that we are comfortable with high risk and with owning lots of shares. But when volatility rises and prices fall, we might lose our nerve and sell. This could be an expensive error, as it causes us to buy when shares are high and sell when they are temporarily low.
Overconfidence can solve this problem. If we convince ourselves that we were right to buy shares even though they've fallen and that we know better than the market, we'll stick to our original asset allocation and so not sell when we hit trouble. In this sense, one cognitive bias - overconfidence - can offset another: time-inconsistent preferences.
In this sense, successful investors can be like actors. Many of these suffer from stage fright – which seems odd given that they chose a profession that by definition requires them to go on stage. This is an example of time-inconsistent risk preferences: something that doesn't seem scary when we are sitting at home becomes terrifying minutes before we have to confront it. One solution to this is to be overconfident: the actor who persuades himself that he'll deliver a great performance steels himself to overcome stage fright.
The payoffs to the steeling effect of overconfidence can be huge. Economists at AQR Capital Management have shown that Warren Buffett's success is due not to picking the right specific stocks but rather from having the right strategy (buying quality defensives) and - crucially - having the conviction to stick with that strategy even during rough periods. You might argue, given his performance, that Buffett's confidence is well-founded. But overconfidence would also have had that steeling effect.
But there's a problem here. It's when we are losing money that we are most likely to believe ourselves to be bad investors and so sell up. And it's when we've done well that we're most likely to become overconfident and so take on too much risk. In this sense, there's a paradox about overconfidence. We are most likely to have it when it is most dangerous to do so, and least likely to have it when we most need it.
