Overconfidence effect

The overconfidence effect refers to the human tendency to be more confident in one's behaviors, attributes and physical characteristics than one ought to be. Surveying drivers, Ola Svenson (1981) found that 80% of respondents rated themselves in the top 30% of all drivers. Overconfidence is most likely after a series of "successes" and can lead to excessive risk taking. This is sometimes used to explain why most investors have too little diversification.

Practical Applications of Overconfidence Bias

Overconfidence bias may cause people to persist in situations where their expected outcome is poor. In some situations, this might ironically cause them to improve their outcomes via greater effort. Nevertheless, this bias can be counterproductive and lead to "exploitable" behaviors.

Example : "Winner takes all" - tournaments for promotion

Many "real-world" situations can be characterized as a rank order tournament. In other words, prizes are not proportional to outcomes, but accrue to the top performers. In many employment situations, only the best performers are promoted - for example tenure in academia, or promotion to partner in consulting or law firms. In such situations, overconfidence bias may :

1) Cause employees to overestimate their chances of promotion, this causes them to overly value the possible promotion as an incentive, because they deem it to be more likely to occur.

2) Cause employees to work harder than they normally would for a chance at a promotion.

3) Prefer tournaments and other compensation schemes where most of the rewards are concentrated at the top, and where the costs of failure are extreme (for example an "up or out" promotion system). The overconfidence bias causes these employees to consider the chance that they will fail to be very slim and to overestimate the chance that they will succeed.

Example : Increased risk taking and insufficient preventive care

Optimistic overconfidence bias also extends to many domains - including health domains. A supermajority of people believe that they are at a below average risk of having bad events happen to them - this includes underestimating the chances of a serious car accident, of cancer or heart disease, or of a divorce. Optimistic overconfidence bias can induce people to underinvest in primary and preventative care and other risk reducing behaviors, like abstinence from smoking.

Example : Credit card borrowing and penalty rates and fees

Overconfidence causes many individuals to grossly underestimate their odds of making a payment late. Statistically, many people are quite likely to make at least one or more payments late due to the normal range of difficulties and delays in day-to-day life. Overconfidence bias causes these individuals to grossly underestimate the odds of this happening, and therefore to accept grossly punitive fees and rates (for example an interest rate of nearly 30 %) as a result of otherwise minor transgressions like a late payment. Other companies now have extended on this approach, by increasing interest rates to punitive rates for any late payment even if it is to another creditor. Overconfidence bias makes these terms more acceptable to borrowers than if they were accurately calibrated.

Overconfidence bias also causes many individuals to substantially underestimate the probability of having serious financial or liquidity problems - for example from a sudden job loss or severe illness. This can cause individuals to take on excessive debt under the expectation that they will do "better than average" in the future and be readily able to pay it off.

Overconfidence, locus[1] of control and depression

Overconfidence bias may cause many individuals to overestimate their degree of control as well as their odds of success. This may be protective against depression - since Seligman and Maier's model of depression includes a sense of learned helplessness and loss of predictability and control. Depressives tend to be more accurate, and less overconfident in their assessments of the probabilities of good and bad events occurring to them. This has caused some researchers to consider that overconfidence bias may be adaptive and/or protective in some situations.

Overconfidence and overvaluing the likelihood of being in the top 1% of incomes

Many people tend to overestimate the likelihood that they will be in the top 1% of incomes. They also underestimate the likelihood that their incomes will fall substantially. This can bias individuals in favor of policies and political views that are quite generous to those at the top of the income scale, and against policies that aid the poor.

Overconfidence and other biases

Overconfidence and escalating commitment

Overconfidence bias often serves to increase the effects of escalating commitment - causing decision makers to refuse to withdraw from a losing situation, or to continue to throw good money, effort, time and other resources after bad investments.

Overconfidence and ignoring of base rates

People often tend to ignore base rates (cf. base rate neglect) or undervalue their effect. For example, if you are competing against individuals who are already winners of previous competitions, one's odds of winning should be adjusted downward considerably. People tend to fail to do so sufficiently.

See also

• Social psychology
• List of cognitive biases
• False consensus effect
• Lake Wobegon effect
• Dunning-Kruger effect

References

• Shefrin, H. (2002). Beyond Greed and Fear: Understanding Behavioral Finance and the Psychology of Investing. Oxford University Press.
• Gilovich, T., Griffin D. & Kahneman, D. (Eds.). (2002). Heuristics and biases: The psychology of intuitive judgment. Cambridge, UK: Cambridge University Press. ISBN 0-521-79679-2