The Bias of Over-Confidence

Behavioral Finance
History
Economics
By
John R. Brock, Ph.D., Vice President

Not only is Adam Smith considered the father of modern economics, he’s also been recognized as the first behavioral economist.  In The Wealth of Nations, Smith addressed one of humans’ most damaging behavioral biases—overconfidence—stating, “The over-weening conceit which the greater part of men have of their own abilities, is an ancient evil…”  Referring to this bias, Nobel Laureate Daniel Kahneman recently declared that if he had a magic wand that could eliminate one human bias, he would do away with overconfidence.  It is pervasive.  Garrison Keillor, host of a popular NPR radio program, ends his weekly monologue about a mythical town saying, “Well, that’s the news from Lake Wobegon, where all the women are strong, all the men are good looking, and all the children are above average.”

A key concern to economists is how overconfidence may adversely affect decision making.  In the Journal of Personality and Psychology, Justin Kruger and David Dunning describe an experiment in which participants scoring in the bottom quartile on tests overestimated their performance to be in the 62nd percentile instead of the 12th percentile.  Earlier this year I attended a lecture by Harvard economist John Campbell at the American Economic Association annual meetings.  Campbell’s presentation, “Restoring Rational Choice,” focused on the problems caused by financial illiteracy.  In referring to a frequently-used measure of financial knowledge—the National Financial Capability Study (NFCS) “Big Five” survey questions—Campbell defined the financially illiterate as those who answer two or fewer of the five questions correctly.  The five questions are relatively easy and cover five fundamental concepts: calculating interest, the effects of inflation on purchasing power, risk and diversification in mutual funds, the relationship between bond prices and interest rates, and the impact that a shorter term has on the cumulative interest and monthly payments over the life of a mortgage.  The NFCS also asks respon­dents to self-assess their own financial capability.

The results are not particularly surprising:  Financial “illiteracy” rates among the young are quite high, with over 50 percent in the age 18 to 30 bracket being financially illiterate.  However, while younger people have lower financial literacy, they are also more likely to recognize this weakness (i.e., lower confidence in financial capability) and be more open to advice.  While overall financial illiteracy declines with age (up to age 65, at which point it begins to rise), older financially-illiterate people are disproportionately confident that they know what they are doing.  This is worrisome, argues Campbell, because these older people are overconfident and thus less open to professional advice and more susceptible to fraud.  Given our tendency toward overconfidence, we would be wise to recall Socrates’ counsel:  “True wisdom comes to each of us when we realize how little we understand about life, ourselves, and the world around us.”  Successful investors need to understand their own limitations and invest accordingly.