Overconfidence

Svenson (1981), Taylor & Brown (1988), Tiger (1979) and Weinstein (1980) provide empirical evidence for the first category of overconfidence: Most people rate themselves above the mean on almost every positive personal trait - including driving ability, a sense of humor, managerial risk taking, and expected longevity. For instance, when a sample of U.S. students assessed their own driving safety, 82% judged themselves to be in the top 30% of the group.

The sources of overconfidence can be indirect, like computational constraints and frictions which diminish the marginal benefits of additional iterations in judgment. Or they can be linked to a different cognition and decision process. For example, individuals may think that they can interpret information better than they really do.

In behavioral finance, the concept of overconfidence might help to explain the high volume of trade observed in financial markets. If one connects the phenomenon of overconfidence with the phenomenon of anchoring, one can see the origins of differences of opinion among investors, and one possible source of the high volume of trade among them.

See also: anchoring, behavioral finance

Literature: Alpert & Raiffa (1982), Benos (1996), Fischhoff, Slovic & Lichtenstein (1977), Frank (1935), Lichtenstein, Fischhoff and Phillips (1982), Svenson (1981), Taylor & Brown (1988), Tiger (1979), Weinstein (1980)

Entry by: Andreas Laschke

November 17, 1997 Direct questions and comments to: Glossary master