OVERCONFIDENCE PHENOMENON

By definition, there is always some uncertainty in probabilistic events. Yet, research has shown that people tend to be more confident in their decisions about probabilistic events than they should be.

In an experimental investigation of the overconfidence phenomenon, people were asked to provide answers with a specified degree of confidence to factual questions (Kahneman & Tversky, 1979). Try it with this question: “I feel 98 percent certain that the number of nuclear plants operating in the world in 1980 was more than _____ and less than ____.” Fill in the blanks with numbers that reflect 98% confidence. The researchers investigating this effect found that nearly one-third of the time, the correct answer did not lie between the two values that reflected a 98% level of confidence. (The correct answer to this question is 189.) This result demonstrates that people are often highly confident when their high degree of confidence is unwarranted.

Have you ever bought a lottery ticket? Do you know what the odds are against your hitting the jackpot? The laws of probability dictate that you should expect to lose, yet countless numbers of people expect to win. In fact, a disturbing poll published in Money magazine revealed that almost as many people are planning for their retirement by buying lottery tickets (39%) as are investing in stocks (43%) (Wang, 1994).

Overconfidence about uncertain events is a problem even for experts in many fields where there is great uncertainty. In an analysis of political predictions (who is likely to win, for example), Silver (2011, para.3) wrote:
“Experts have a poor understanding of uncertainty. Usually, this manifests itself in the form of overconfidence: experts underestimate the likelihood that their predictions might be wrong.”

Overconfidence can be disastrous for financial investors. In a study of individual investors, two economists found that most people fail to recognize the role that chance plays in the stock market, so they tend to attribute gains to their own expertise in picking stocks and losses to external forces that they could not control. The result is that overconfident investors trade their stocks far too often because they believe that they are making wise choices (Gervais & Odean, 2001). If they could recognize the effects of random fluctuations in the stock market instead of attributing the changes to their own trading behaviors, they would have traded less often and ended up in better financial shape.


TOPIC: #CognitiveBiases
SOURCE: Thought and knowledge: an introduction to critical thinking by Diane F. Halpern