Overconfidence Bias

The Story

James had done well picking a few stocks during the pandemic recovery. His portfolio was up 40% in 2021, and he started telling friends he had "a knack for the market." He quit using his ISA's default index fund and began actively trading individual shares on his Stocks and Shares ISA.

By the end of 2022, James had underperformed the FTSE All-Share by 15 percentage points. He'd concentrated his holdings in UK tech firms he was "certain" about, ignored diversification, and traded far too frequently — racking up fees along the way.

James wasn't unintelligent. He was overconfident.

What Is Overconfidence Bias?

Overconfidence bias is our tendency to overestimate the accuracy of our beliefs and predictions. It shows up in three ways: we think we know more than we do (overprecision), we overrate our own abilities (overestimation), and we believe we're better than others at the same task (overplacement).

In studies, when people say they're "99% certain" about something, they're wrong roughly 40% of the time. Our internal confidence meter is badly calibrated.

Overconfidence in Finance

This bias is arguably the most expensive one in personal finance. Research from Barber and Odean (2001) analysed 66,465 US brokerage accounts and found that the most active traders — those most confident in their ability to pick winners — earned annual returns of 11.4%, while the market returned 17.9%. Confidence literally cost them money.

In the UK context, overconfidence drives several costly behaviours. People underestimate how much they need for retirement — a Scottish Widows survey found that the average Briton thinks they need around £250,000 for a comfortable retirement, while the Pensions and Lifetime Savings Association suggests the figure is closer to £530,000. That gap is overconfidence in action.

It also fuels the persistent belief that you can "beat the market." Data from S&P Dow Jones consistently shows that over 90% of actively managed UK equity funds underperform their benchmark over a 15-year period. Yet many investors remain convinced they — or their fund manager — will be the exception.

"The greatest enemy of knowledge is not ignorance; it is the illusion of knowledge." — Daniel J. Boorstin. Research by Moore and Healy (2008) demonstrated that overconfidence is one of the most robust findings in the psychology of judgement, appearing across virtually every domain studied.

How to Protect Yourself

Track your predictions. Start writing down your financial predictions with dates and specific numbers. "I think this share will be worth £X by December." Review them quarterly. You'll quickly discover how often you're wrong.

Assume you're average. Unless you have genuine evidence otherwise, assume your investment returns will be average. For most people, a low-cost global index fund through a platform like Vanguard or Fidelity is the most rational choice.

Use pre-commitment. Set up your pension contributions, ISA investments, and savings by direct debit. Automate your finances so that overconfidence doesn't tempt you into tinkering.

Seek disconfirming evidence. Before making any financial decision, actively look for reasons you might be wrong. If you can't find any, you haven't looked hard enough.

Diversify broadly. Overconfident investors concentrate. Wise investors spread their bets. A simple portfolio of global equities and bonds protects you from being wrong about any single bet.

Reflection Questions

• When was the last time you were completely wrong about a financial prediction?
• Do you believe you're a better-than-average investor? What evidence do you have?
• How much of your past financial success was skill, and how much was luck or market conditions?

Research Note

Key references: Barber, B.M. and Odean, T. (2001) "Boys Will Be Boys: Gender, Overconfidence, and Common Stock Investment," The Quarterly Journal of Economics, 116(1), pp. 261-292. Moore, D.A. and Healy, P.J. (2008) "The Trouble with Overconfidence," Psychological Review, 115(2), pp. 502-517. UK fund performance data from the S&P Indices Versus Active (SPIVA) Europe Scorecard.