Following on from a previous look at base rates and Bayes’ theorem, I have been considering the topic of overconfidence. All of us make decisions of varying magnitudes on a regular basis, in the face of certainty and uncertainty alike. Due to the tendency of things to err on the side of the latter (especially when it comes to investing!), the use of judgement and estimates becomes an unavoidable aspect of our decision making. Should we leave this process unchecked? Or can improvements be made?

The Problem

Confidence is a powerful force indeed. It can get you through when the going gets tough but at the same time we know what they say about too much of a good thing. There is a difference between justified belief and wishful thinking and, if left unchecked, overconfidence can spell disaster for your portfolio. Having made the mistake myself, I understand the consequences all too well and, worst of all, know how hard it can be to recognise the symptoms in advance.

Hard, but not impossible. Well, the first step to recovery is admitting you have a problem so perhaps that is the place to start. For this purpose, I have borrowed a simple test format first used by Edward Russo and Paul Schoemaker in their 1989 work ‘Decision Traps’. I have seen the test used in a few different places (notably in an excellent paper called The Seven Sins of Fund Management that I would recommend to all), although I have made up my own set of questions in order to first perform a fresh test on myself.

The Test

There are 10 questions, all with numerical answers and with no research necessary. Instead, you are required to estimate the lower and upper bound of your 90% confidence interval for each one:

  1. What is the distance between the earth and the moon in kilometres?
  2. What is the speed of sound through water in metres per second?
  3. In what year was the Louisiana Purchase completed during Thomas Jefferson’s presidency?
  4. If spun out to form a single thread, what would be the length of the entire human circulatory system in kilometres?
  5. What is the top recorded speed of a pigeon in flight in miles per hour?
  6. What has been the annualised return of the S&P 500 since 1970 with dividends reinvested?
  7. What is the population of Thailand?
  8. At what temperature does iron melt?
  9. How many unique…

Unlock the rest of this article with a 14 day trial

Already have an account?
Login here