Bestiary of Behavioral Economics/Overconfidence

Overconfidence is a common tendency to overestimate one's ability to predict and control future outcomes. It is recognized in psychology as well as economics and has been blamed for countless counterintuitive economic outcomes.

Three Main Types of Overconfidence

Moore and Healy identify three broad types of overconfidence: overestimation, overplacement, and overprecision.

Overestimation

Overestimating one's ability, knowledge, or performance. For instance, a person could overestimate their ability to complete a puzzle within a time limit. Interestingly, subjects tend to overestimate their skill on difficult tasks and underestimate it on easy tasks.

Overplacement

Overplacement, or “the better-than-average effect”, is the belief that one is better than others. If a person believes that they can solve the puzzle faster than 90% of their peers, they are demonstrating overplacement. When asked about positive abilities, such as driving ability, in relation to one's peers, 90% of participants believed themselves to be in the top half.

Overprecision

Overconfidence when estimating future uncertainty. This is usually related to forecasts (of, say, stock prices).

Additional Types

Miscalibration

Fellner and Krügel define miscalibration in order to challenge its importance to overconfidence. Miscalibration, or “misperceiving the reliability of signals and results in overweighting private information”, is a conflict between observed information and private information--knowledge one already possesses or information only one is privy to.

Optimistic Overconfidence

'Optimistic overconfidence' deals specifically with the intersection between high levels of confidence and unrealistic optimism. Kahneman and Tversky discuss how the two feed off of each other, potentially leading to irrational escalation.

Societal Differences in Overconfidence

Differences in culture and society can lead to the development of overconfidence in different areas of life. People in individualistic societies (such as the USA) tend to develop overconfidence in areas that allow them to believe they can compete better that others. For example, one would be likely to think that they are more intelligent than others. People in collectivistic societies (such as Japan) tend to develop overconfidence in areas that allow them to better contribute to society and make them good members of society. For example, one would be be overconfident in the capacity of their loyalty and honesty as well as that of others. But, these general stereotypes do not prohibit members of "opposing" societies from engaging in similar behavior. For example, a member of a collectivistic society can still be an entrepreneur because they are confident that their society will support them even in failure. Thus, multiple types of overconfidence can be the driving force behind one particular action or behavior.

Relation to Gender

Overconfidence is generally higher in men than in women. For example, as shown in a study by Barber and Odean, men usually trade more frequently than women in financial markets and usually have greater losses. In the experiment it was shown, contrary to the beliefs of many, that overprecision does not lead to the difference in trading behavior. Rather, it is overplacement that accounts for the trading differences between the genders and for high overconfidence in men.

Economic Applications

• Camerer and Lovallo tested the effect of overconfidence on business entry. Their experiment compared business entry decisions with personal overconfidence, in which participants were to enter a market and earn profits based on either chance or their own skill. While 77% of the chance-based rounds turned profits, the average profit for skill-based rounds was negative in 42% of the rounds.
• During the Great Recession, Polish financial experts and laypeople were asked to make predictions about stock and exchange markets. While the experts were not substantially better at predicting the markets than the laypeople, they were much more confident in their predictions.
• A more general example is that of the amount of trading in the stock market. If stock holders are fully rational, why do they trade so much? Overprecision is one explanation. If traders are overconfident in their estimated value of a given stock, they could be too willing to trade with others who have different estimations.