The Paradox Of Being Overconfident

Although human beings have been around for about 200,000 years, it wasn’t until about 11,000 years ago that our ancestors began making the transition from hunter-gatherers to what we now call civilization. And, while the environment we have built for ourselves has rapidly progressed since then, especially in the last few centuries, the human brain has evolved at a glacial pace. Our brains today aren’t much different from when we were hunting bears, fighting lions, and gathering crops.

We like to think of ourselves as beings of reason and logic, but our decisions are driven largely by instinct.

John Maynard Keynes, a famed early 20th century economist who was well aware of this phenomenon wrote about what he called “animal spirits” and his observations anticipated contemporary research into how our everyday decisions are distorted by cognitive bias, overconfidence and emotion.

Daniel Kahneman, a psychologist by training, found that his research into brain function had a special relevance to decision making, and who would eventually go on to win a Nobel Prize in Economics (after all, economics is the study of how humans respond to incentives).

In his book Thinking, Fast and Slow, he identified two styles or modes of thinking. The first works quickly and intuitively, relies heavily on association, and is easily swayed by emotion. The second is deliberate, methodical, and logical — but also very slow. Neither is better, and we need both of them. Every day, every hour, we process huge amounts of information, and make hundreds of decisions, both large and small. We don’t have time to work through it all slowly and carefully, which is where our intuitive, instinctual thinking comes in to play. Intuitive thinking has emerged as an evolutionary necessity, and it’s spot on a good deal of the time.

But, because it relies on taking shortcuts, it’s also vulnerable to what scientists call cognitive bias — ways in which those same shortcuts lead us to flawed conclusions. Experts have detailed as many as 58 different varieties of cognitive bias that can lead to poor business decisions. Many stem from the “narrative fallacy” — the tendency of the brain to create coherent stories based on random facts, and to see cause and effect where there is none.

One of the most prevalent biases is overconfidence also known as illusory superiority or self-serving bias.

For instance, a well known study in the early 1980’s showed that 93% of Americans thought that they are above-average drivers.

In a more recent study (2006), James Montier found that 74% of money managers surveyed believed they delivered an above-average performance (which obviously isn’t true).

Overconfidence has been found to be more of an occurrence in men than women. UC Berkeley Professors Brad Barber and Terrance Odean analyzed 150,000 accounts at discount brokerage firms and found that women earn 1.5% more per year than men (single women earn 2.5% more than single men). The difference was not due to stock picking (both were poor stock pickers) but, instead, was a result of turnover and the amount of trading. Odean found that women turn over around 50% of their portfolio per year while men turn over nearly 80%. It seems that the most likely reason for this is that males suffer more from illusory superiority and trust their decision-making abilities more than females

Overconfidence has always been and will always be a part of human nature. It may have even been an important survival instinct in the past. After all, survival back in the day often required risk taking (going into the wilderness to hunt or defend your tribe). Ones that weren’t inclined to take these risks may have had inferior chances of reproducing.

And today, overconfidence is a common trait of many of the most successful business owners. It’s the overconfident ones who take risks. Who launch companies and whose worth is largely made up of equity, not salary.

Overconfidence spurs action, which over time, creates results!

But it can cause people to make poor decisions also. For instance, former General Electric CEO Jack Welch admitted he bought the brokerage firm Kidder Peabody (even though he knew “diddly” about it) because he felt like he couldn’t be beat.

Welch was too focused on the potential favorable outcome that he became complacent and ignored his general due diligence process. This teaches us a lesson. If someone as intelligent and careful as Jack Welch was able to stumble, we need to be mindful!

In a study published in the journal Neuron, researchers using magnetic resonance imaging (or MRI) found that sudden financial gains stimulate the brain in ways similar to “euphoria-inducing” drugs like cocaine, and that these brain patterns also resemble those experienced during sexual arousal. Moreover, even the anticipation of such gains was enough to fire up the brain’s pleasure center.

This overstimulation can collude even the most careful people into making the wrong decisions at the wrong times. But if you follow a set of guiding principles, you can minimize your mistakes, make more good choices than bad, and maybe even profit from the mistakes of others:

Here are three ways overconfident people can protect themselves from poor decisions:

1) Be A Healthy Skeptic.

A big part of being a healthy skeptic is being selective, and a bit suspicious about the information you consume. A good deal of your perception is based on your emotions, especially greed and fear. Learn to identify when you’re susceptible to these emotions and try to refrain from making decisions at that time. If this isn’t possibly, run your train of though by others.

2) Don’t Predict Outcomes

Although some people credit him with predicting the collapse of the sub-prime market in 2007, Nassim Nicholas Taleb (author of Fooled By Randomness, The Black Swan, and Antifragile) isn’t a fan of making predictions. Instead, he argues for what he calls “non-predictive decision-making” — a stance that is very similar to Meir Statman’s advice to prepare rather than predict. Regardless of the probability of a negative outcome occurring, you should always be prepared in case one does.

3) Know What You Don’t Know.

Know thy enemy and know thyself. A central insight of behavioral economics is our tendency to see cause and effect where there is none, to think we know more than we know. Guarding against this is crucial. Even George Soros, one of the world’s great investors, with a cumulative rate-of-return that rivals that of Warren Buffett admits he is “overwhelmed,” by the persistent reality of uncertainty. “I’m constantly on watch, being aware of my own misconceptions, being aware that I’m acting on misconceptions and constantly looking to correct them.”

This article initially appeared here.