There’s a line in Warren Buffett’s 2000 letter to Berkshire Hathaway shareholders, where he says: “Nothing sedates rationality like large doses of effortless money.” *
At the time, of course, Buffett was reflecting on two years of “irrational exuberance” that had swept through the U.S. market - propelling the prices of tech stocks (which were then starting to crash back down).
He noted: “It was as if some virus, racing wildly among investment professionals as well as amateurs, induced hallucinations in which the values of stocks in certain sectors became decoupled from the values of the businesses that underlay them.”
Buffett’s comments are an interesting first-hand account of investor behaviour during a market bubble. A lot of what he describes tallies with what psychologists know about bubbles - which is that overconfidence plays a big part in them.
In the UK, there are few signs that the market is in bubble territory. But that doesn’t mean that investors shouldn’t be wary of the risks of overconfidence. In a recent article on this subject, Don Moore, a professor specialising in this field, described overconfidence as “the mother of all biases”.
That’s because it not only leads to over-trading but it can also exacerbate Action Bias and a range of other ‘Belief Perseverance’ issues spanning Confirmation Bias, Conservatism, Illusion of Control and Representativeness. While Moore wasn’t directly referencing the stock market, there is no shortage of evidence that this particular behavioural trap can be costly for investors who fall into it.
Overconfidence is costly
Studies show that people naturally tend to be overconfident, and it shows itself in a couple of ways:
It can be seen in people who think they know more than they actually do.
It can also be seen in people who think that they (and their abilities) are better than average (the ‘better-than-average effect’).
From the point of view of investing, there’s a lot of research that links overconfidence with underperformance. We’ve covered this subject in the past, and separately there are great summary articles by Timarr here and here.
The general thrust from the academic studies is that overconfidence leads to over-trading. And those who trade the most perform the worst. In addition, findings show that men (who are generally more overconfident than women) churn their portfolios more and, as a result, perform…
