Overconfidence breeds poor returns

By Vikram Barhat | March 31, 2010 | Last updated on March 31, 2010
2 min read

Investors are an awfully smart bunch…just ask them. You’d have a hard time finding one that would say they are below average.

Expectations of personal success are generally far higher than probability actually warrant, says Michael S. Falk, CFA, vice-president and chief investment officer, ProManage, a U.S.-based financial services firm.

The objective of the presentation was to help investors understand their own behaviour of pattern searching, anchoring, overconfidence, illusion of control or loss aversion. It included an overview of Neuroscience 101 to provide investors with an understanding of the decision making process and triggers that impact this process.

Falk, a member of the CFA Institute’s Speakers Program, was in town to speak at a behavioural finance seminar organized by the Toronto CFA Society.

“In most 50-50 bets, like a coin toss, overconfidence is greater than 50%, in contradiction to fundamental probability, arising from an illusion of control,” Falk told the audience, highlighting biases in decision making.

Behavioural finance is the study that deals with the influence of human psychology on the decisions of financial practitioners and the subsequent effect on markets.

“We are a fascinating species. We search for patterns in everything. Even when we are told they don’t exist, we still search,” he said, referring to perceptions that make decisions appear sound but turn out badly. “Finance is probability, and we often contradict fundamental probability within the heuristics.”

He shared various studies and their results to explain how social, cognitive and emotional factors shape the economic decisions of consumers, borrowers and investors, and their effects on market prices, returns and the allocation of resources.

By applying theories in behavioural science and neuroscience to finance, Falk explains that investors can make sense of periodic bubbles in the global economy and understand the role of human behaviour in market anomalies.

The tendency to ignore the odds is a gambler’s fallacy also known as the representativeness heuristics, a rule of thumb wherein people judge the probability or frequency of an occurrence by a situation’s resemblance to available data.

“As few as two in a row of anything will actually trigger the inner brain to expect a third. Market prices are random and yet we still find patterns,” he says. “People who trade, trade too much, because they think they are right.”

He says frequent trading is a sign of overconfidence and the reason why some people under-diversify and, hence, underperform.


Vikram Barhat