The desire to grow wealth and earn passively is one we can all relate to. While we certainly stand to benefit from having a healthy investment portfolio, investing is not a panacea for all our financial worries — and it can be tricky to navigate, especially with the cognitive biases that are often at play. One such is the overconfidence bias. Put simply, this is when a person overestimates their level of skill and knowledge, consequently making more risky decisions and attributing their past failures to external factors. This can affect their financial behaviour in a few different ways — it could leave them with a portfolio crowded with identical investments, or take them to the other extreme, where there’s too much going on.
Overconfident people tend to underestimate potential risks and overestimate the expected rewards. Such a person might turn away from stable investments that may not yield high returns, be inclined towards more volatile asset classes, take on a large loan, or not purchase insurance — because they neglect to consider negative outcomes.
To illustrate, they may gravitate towards high-risk, high-return instruments like penny stocks, small-cap stocks and crypto, while overlooking less risky instruments like index funds. They are also likely to be inclined to stick to certain asset classes, especially ones that have worked well for them in the past. Even within an asset class, an overconfident investor may arbitrarily gravitate towards certain stocks, funds, or tokens that they see as profitable. This narrow-mindedness can lead to a concentrated portfolio.
The lack of diversity also translates to slower growth. When you park your investments in similar assets, the odds of the portfolio underperforming increase. Over-allocating funds in a few holdings can negatively impact your future cash flows, and possibly defeat the purpose of investing to keep up with inflation. Risk and potential returns are subjective. It’s important to strategically plan for different outcomes, even if you’re making a sure bet.
Interestingly, an overconfidence bias could also lead to an over-diversified portfolio. It would manifest differently in this case, with investors wanting to invest in many different asset classes. They may think that they can earn good returns on whatever they invest in, and cast a wide net. This too is unfavourable. Fragmented investments often lead to lower returns overall, since even well-performing assets can be overshadowed by losses and stagnant growth in other areas.
This is also why a large and diversified portfolio may not always guarantee financial well-being. Diversification needs to be carried out intentionally, and across a handful of carefully selected asset classes that are likely to perform well, suit your behaviour, are easy for you to manage and don’t seem out of place in your larger financial plan.
It’s important to be self-aware when building your portfolio — it’s best to employ an outsider’s perspective to catch these biases, be clear about the true risks and rewards of your investments, and make sure your overconfidence doesn’t get the better of you.