Cognitive biases in psychology influence our behaviour with money. If you missed the first instalment in this series, where I explained our heuristics and biases in decision making, you might want to go read that first. There are some useful System 1 and System 2 thinking examples that will introduce you to the workings of your brain. For this post, we’re focusing on the impact of overconfidence bias in decision-making. Nothing wrong with being confident and boosting your self-esteem, but having an awareness of some of our inaccurate decision making as a result of our self-serving bias can be beneficial. We need to strive to be better than average when it comes to managing our heuristics.

If you want to jump ahead, we’ll be covering the following:

1. Overconfidence bias in decision-making
2. The illusion of knowledge bias
3. The illusion of control bias
4. Confidence vs Carelessness
5. Better than average effect
6. Self-serving bias
7. Fundamental attribution error
8. How to overcome overconfidence bias

As individuals, we overestimate our own skills and chances of success. This leads to overly positive self-evaluations of our intellect or talent (particularly with difficult tasks). As these self-evaluations are often unrealistic, this results in the overconfidence effect. Put simply – we tend to believe that we’re better than what we actually are!

Our exaggeration of our own abilities and our overconfidence in decision making is innate in all of us, but more prevalent in those who think they know more than others (the illusion of knowledge bias) and think they can influence the outcome of a situation (the illusion of control bias).

The illusion of knowledge bias might sound like something that’s more prevalent in professionals i.e. finance people think they understand financial markets well, and thus they believe they’re better at picking good investments. But that overconfidence bias in decision-making can often work against them.

It happens to all of us though. As humans, we don’t like uncertainty. Thus – we tend to try and collect as much information as possible when faced with uncertainty. This results in us thinking that we have better information and that we know better than others who don’t have this information. And then we act on that – psychology overconfidence.

Let’s say you’re trying to decide between the new Iphone or the new Samsung. You start to gather information to help you with this decision. (For the moment, let’s ignore confirmation bias and focus on overconfidence psychology only.) Now that you’ve gathered all the information and you interpret the IPhone to be the winner, you buy the Iphone under the illusion of knowledge. Next, you consider buying shares in Apple (here goes that overconfidence bias in decision-making). Given your illusion of knowledge has already convinced you that the Iphone is the best phone, you assume that everyone must be buying Apple products and thus the share price will go up. That’s the illusion of control. Just because you (correctly or incorrectly) like the product, doesn’t mean you have any control over what happens to that company’s share price on the stock market.

This illusion of control bias is often exploited in advertising where marketers try to enhance the perception of control that someone might have. A study which looked at sports betting in the UK found that the adverts commonly played up themes of sports knowledge and masculinity to construct a narrative that manly men who know about sport have a better chance of winning (Nice try!)

How often do you complete a project in less time and at a lower cost than you forecasted? I’m guessing not often. Such delays and cost overruns because of unrealistic forecasts are renowned: consider the Sydney Opera house, the Airbus A400m, or Boston’s Big Dig. Overconfidence has also been blamed for a number of disasters ranging from the dotcom bubble in the 1990’s to the sub-prime lending crisis. Examples of overconfidence in history include the First World War and the War in Iraq. I think the only professionals somewhat immune to this bias are the weather forecasters!

Overconfidence is also more pronounced in men than it is in women. Studies of investor behaviour show that overconfidence phenomenon results in investors thinking they know more than they do or that they make better decisions than they do. Among the consequences of this resultant overconfidence decision making is the tendency to take more risk than is reasonable and to trade too often. Male investors have been seen to trade more frequently because of this, which then lowers their overall return.

You might be thinking “I know everyone else might think they’re good, but I really am better than average at my job”. Maybe you are. But this is a classic better-than-average effect psychology example. Given so many studies show that most people rate themselves above average, it is statistically impossible. At least in Western cultures, across age group, ability domains, and occupations, when asked to evaluate abilities, most people say they are better than your average person. Even for those that don’t think they’re above average, very few say they are below average. Have we forgotten that ‘average’ refers to the arithmetic mean?

Consider the driver that thinks they’re better than average. If they believe they are a skilled driver able to handle a dangerous situation on the road, then that situation will not be interpreted as dangerous. Thus, overconfident individuals might be less likely to take precautions. This has implications for our decisions, particularly those pertaining to insurance cover.

The one reprieve we have against this perceived unrealistic optimism is that our comparative judgments might be skewed by what we view ‘average’ to be. A notable study had participants rate their abilities and compare themselves relative to an average student and a typical student. You would expect the results to sit on the same scale but the ability judgments showed that participants rated and viewed an average student as a typical student with below-median abilities. This infers that when we say we are better than average, we’re actually saying that we’re better than someone with below-median abilities. (Isn’t it interesting how we’ve changed the better than average meaning?)

Now that we know we think we’re better than average and that we display overconfidence bias in decision-making, how do we then rationalise things when they don’t go the way we thought they would? Easy – we say we were unlucky. Or we blame someone else.

This is what’s known as the self-serving bias or self attribution bias. It’s a phenomenon whereby we attribute any successful outcomes to skill and any unsuccessful outcomes to bad luck. Again, men, this bias is more prevalent in you. Therefore, I’m going to use a sports example to explain it (Am I stereotyping?).

Post-match commentary 1 happens when we win. Post-match commentary 2 happens when we lose. The notable difference is that when we win, it’s because we were good, we deserved it. But when we lose, we deflect the negative outcomes. That’s the self-serving bias. 

It’s a bias that you can also see play out in children. If they get an A on their report card they take the credit (which they should) because it affirms them being smart and working hard. But if they get an F on their report card, they usually start by blaming external factors, like the teacher doesn’t like them, or the test wasn’t fair. (And as parents, we’re often guilty of affirming this self-serving bias in our children.)

A close-cousin of these self serving biases is the fundamental attribution error. This bias occurs when we attribute other people’s behaviours to their dispositional factors ( personality traits, temperament, genetics) while attributing our own actions to situational factors.

Why do we do this? Quite simply, because it makes us feel better. It boosts our self esteem which is good for our mental health. And it doesn’t cause any harm in most situations. However, if we cannot as older adults accept personal responsibility for our failures, only our successes, it can cause harm. To more than just ourselves. Thus, an awareness that this self serving bias occurs and that we tend to attribute negative events to the wrong place, while difficult, is important.

Consider Richard Fuld, the invincible CEO of the investment bank Lehman Brothers until it went bankrupt in 2008. In a Testimony to Congress on the Lehman Brothers Bankruptcy, he stated that Lehman’s demise was brought on by many destabilising factors: the collapse of the real estate market, false rumours, rating agency downgrades and widening spreads on credit default swaps. While I’m not insinuating that these events didn’t play their part, there does seem to be an emphasis on blaming the lack of government intervention for the bank’s collapse?

A research article published in Social Psychology Quarterly, a social and personality psychology journal, showed that self serving causal attributions become weaker when acting in a group (or team dynamic) than on our own. Another book on social comparison reviewed studies which asked participants to rate their performance against other individuals and provides further information about the influence that cultural psychology could have in managing our self serving attributions.

The above quote comes from Rudyard Kipling’s inspirational poem: If. (Well worth the read if you don’t know it.) Being poetry, there’s more than one interpretation of this line, but the interpretation that speaks to the self serving attributional bias is that you need to acknowledge the relativity of both positive events and failure and treat them both the same.

We need to be aware that we tend to overestimate our knowledge and ability. We’re overconfident that we won’t lose our job (so we don’t have income protection). We’re overconfident with our investing decisions and thus we overtrade (and incur higher trading costs). Our overconfidence bias in decision-making can land us in trouble!

We also need to learn to be sceptical of any predictions, particularly from experts. When making plans, budget for the more pessimistic scenario. That way, you can judge the situation more realistically and not be surprised by any cost-overruns.

With self-serving bias, you need to be careful in how you reflect on your investing decisions. When your investments do well, do you think it’s because you chose them well? And when they don’t, do you blame the fund manager? Or your financial adviser? Being selective with information and blaming external factors when things don’t work out is a dubious way to plan for your financial future. Rather, be open to taking responsibility for your finances.

Learn how to confront unpalatable truths and get out of any false sense of comfort. Reassess your definition of better than average. Do you have friends who tell you the truth, without holding anything back? If so, you’re off to a good start. If not, find yourself just one honest person and ask them what their opinions are about your strengths and weaknesses. It might be difficult to hear, but you’ll be forever grateful. Are you up for the challenge?

• Heuristics and biases in decision making – This was the first post in the series which shares some behavioural economics research. Specifically, the heuristics and biases that influence our relationship with money. It uses System 1 and System 2 thinking examples from Daniel Kahneman’s New York Times best selling book, Thinking Fast and Slow, to help us be more conscious of the workings of our brain. 

• Why you can’t argue with a vegan – Ballsy title, we know. But if you read the post you’ll (hopefully) understand why. We’ll be discussing confirmation bias. It’s one of those psychological biases that you can see everywhere. We’ll also touch on cognitive dissonance theory. We all struggle with these biases. They’re both humorous and serious. But because of that, it’s useful to know how to avoid confirmation bias when you need to.

• Size does matter… when it comes to framing – This post uses framing effect examples to show how framing bias influences the way we interpret information and make decisions. We discuss glossing, the compromise effect, and how the size of the frame can influence the volatility of your investment portfolio.

• Loss aversion vs risk aversion – Once you understand framing, you’re ready for this post. It introduces an incredibly powerful bias known as loss aversion. It also touches on prospect theory, the disposition effect and impression management.

• Anchors pulling you down? – Anchoring bias is a straightforward behavioural bias that causes us to focus on a certain initial value and then make decisions with reference to it. This post looks at some examples of this anchoring effect.

• The danger of the default – Default options nudge us to make better decisions. The option of opting out also respects freedom of choice. This post unpacks this notion of libertarian paternalism and the perils of status quo bias.

• Regret, it’s not a nice feeling – Regret influences the decisions we make and pushes us to conform to social norms. Examples of regret avoidance show us how this makes complete sense yet no sense at all.

• When the past influences the future – The Concorde effect is a famous example of sunk cost investment. Too often we invest time, money and energy into something we should’ve just abandoned. This post looks at some examples of how sunk cost fallacy affects our human decision processes.

• What’s mine is more valuable – In this post, you’ll learn why you place extra value on things you own. The endowment effect has implications for our investment portfolio, bonuses and consumer behaviour.

• How to improve self-control – Self-control is an essential life skill. It’s what separates humans from the rest of the animal kingdom. Learn how to improve self-control to achieve your long-term goals.

• Procrastination is the enemy of success – We know procrastination is the enemy of success. But while it looks like laziness, it’s often just mental exhaustion at play. Learn how to overcome procrastination.

• The problem with wanting it now – When you delay instant gratification, you will experience long-term satisfaction. It’s the hyperbolic vs exponential discounting debate. Don’t let present bias win!

• The power of first impressions – The order of information influences your decisions. First impressions matter! It’s all got to do with primacy and recency effects.

• We prefer wrong information to no information – Availability bias and survivorship bias influence our decision-making. We make decisions based on the information available to us.

• Learn to deal with uncertainty – Risk and uncertainty will always surround us. Gambler’s Fallacy, the hot-hand effect, the law of small numbers & ambiguity aversion are just some of the biases that arise because of it.

• Stop stereotyping – Representativeness heuristic refers to the fact that we stereotype. It’s a mental shortcut. But beware of making unfounded comparisons.

• Mental Accounting – Money is money! Or is it? Mental accounting says we place different values on different money which leads to irrational decision making.

• Money Illusion– Money illusion is a sneaky bias. It causes us to focus on the amount of money in our hands, rather than it’s purchasing power.

• Home bias – We invest close to home and in what we know. But this lack of diversification results in missed opportunities. Say hello to ‘home bias’.

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