Overconfidence is bad for your wealth, according to new research
Daniel Czaja and Florian Roder, two economists at the University of Geissen, studied 45,000 comments posted on a trading platform by 2,000 traders and found that those who attributed good returns to their own skill rather than to luck subsequently did worse than other traders. “Self-enhancement bias leads to future underperformance,” they conclude.
This corroborates earlier research. Brad Barber and Terrance Odean, two California-based economists, have shown that overconfident investors trade too much and see worse returns. Economists at the University of Mannheim have found that sophisticated investors buy expensive but poorly-performing actively managed funds in the mistaken belief they have the ability to spot good fund managers. And good past returns, even over short periods, can embolden traders to take on too much risk and so lose money.
All this poses the question: if overconfidence is so dangerous, why is there so much of it?
One answer lies in something else that Messrs Czaja and Roder found. The trading platform they studied issues products that allow others to invest in replicas of other traders’ portfolios. They found that “traders prone to the self-enhancement bias attract significantly higher investment flows”.
This is consistent with something discovered by Cameron Anderson and Sebastien Brion at the University of California Berkeley. They show that people mistake others’ overconfidence for genuine ability and so are more likely to hire them.
This might not be wholly irrational, however, as new research by Jung Hoon Lee of Tulane University and Shyam Venkatesan at the University of Western Ontario shows. They describe how it can make sense to hire an overconfident fund manager because his belief that he can beat the market will encourage him to work harder.
Of course, this only makes sense if there are underpriced shares that can be discovered by hard work, which is questionable. But it’s likely that a similar thing is true in other jobs. The overconfident boss who thinks he can turn a company around is likely to work harder, and perhaps succeed, than the man who thinks he has no chance. Or the lawyer who overconfidently believes he has a winnable case will work harder than one who believes the cause is hopeless. And so on. As Arsene Wenger said: “If you do not believe you can do it then you have no chance at all.”
Overconfidence is so common, therefore, in part because it sometimes works. It gets people into top jobs and might cause better performance in them. The problem comes when we transfer overconfidence from domains where it is useful to ones where it is not. Investment is likely to be in the latter category.
