Definition of overconfidence

In business or trading, an overestimation of one's abilities and of the precision of one's forecasts. Overconfident people set overly narrow confidence intervals in making predictions. They tend to overweigh their own forecasts relative to those of others.

The self-serving attribution bias, under which individuals attribute past successes to their own skills and past failures to bad luck, can lead to overconfidence.

In the context of financial markets, the confidence of a self-attributing investor increases when public information is in line with his or her forecast, but it does not decrease as much when public information contradicts his or her forecast. The investor therefore gains excessive confidence over time, after receiving different confirming and disconfirming public news.

A similar cognitive bias, illusory superiority (or the above average effect), also causes people to overestimate their own abilities. Evidence of this bias is documented in studies that ask subjects to assess their abilities - indeed, a vast majority of people say they are above the average.

Example

Investors who overestimate their own abilities trade excessively, even though trading is costly and lowers their net returns. Overconfident managers can make suboptimal investment, mergers and acquisitions and financing decisions, destroying company value. [1]

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