Thursday, April 9, 2020

The Danger of Overconfidence

There is an interesting lecture on Behavioral Finance by Yale professor Robert Shiller. In it, he spoke about how people tend to be overconfident. They overestimate their ability to perform. It happens not just in the financial world, but also in our daily life. One example Robert Shiller gave is that students tend to overestimate how their college’s team will perform in a match against other college.

I have an experience with overconfidence myself. A few years ago, I and some friends worked on a software project. We estimated that we could finish the project in three months. Do you know how much time it eventually took? Fourteen months! That shows how I and my team underestimated the complexity of the project and overestimated our ability to handle it.
So, overconfidence is a common problem. Being pessimistic isn’t good, of course. But being overconfident isn’t good either. Here are two reasons why:

1. You may fail to deliver on your promise 
That’s what happened to me and my team. We failed badly to deliver on our promise. That lesson taught me to be more careful and realistic next time.

2. You may blame yourself too much 
This is the other side of being overconfident. When you are overconfident about something and fail, you may blame yourself too much for the outcome. Robert Shiller mentioned a finding in Searching for a Corporate Savior about how companies often fired their CEOs who didn’t perform as expected even when the entire industry actually declined. The CEO couldn’t be blamed for an industry-wide problem, but the board – who had initially been overconfident with the ability of the”charismatic” CEO – still put the blame on him. This happens at individual level too. You may put all the blame on yourself which make it difficult for you to move forward.
Now that we’ve seen the danger of overconfidence, how can we overcome it? Here are some tips:
1. Acknowledge the role of luck
Many people in the financial market think that they can predict how the market will do. The more they make correct predictions, the more they are confident about their ability. They aren’t aware that in many cases they are just lucky. Hard work is important, but luck does play a big role.
Paul Graham once wrote that Bill Gates is a very smart man, but he is also very lucky. Without the luck factor, he would probably end up near the bottom of the Forbes 400 instead of being one of the richest men in the world. Bill Gates himself said on different occasions about how lucky he is.
Outliers by Malcolm Gladwell discusses the role of luck at great length.

2. Don’t credit yourself too much
Continuing the previous point, be careful not to credit yourself too much when you are successful. Remember that you are probably just lucky.
This doesn’t mean that you don’t need to work hard. After all, successful people are those who capitalize on luck with hard work. But without luck, hard work won’t mean much either.

3. Comprehend the complexity of a project
When you are about to take a project, dig deep into it to really understand the breadth and scope of the project. Be on the lookout for potential pitfalls. Taking the time to really understand the complexity of a project helps you avoid unpleasant surprises later on.

4. Have a cushion
Even after you comprehend the complexity of a project, you still need to have a cushion. Give yourself extra time and resources for unexpected things. But be careful not to give yourself too much cushion. Otherwise you may become less competitive than your competitors.

5. Be prepared for failure
Some people are so confident in themselves that they can’t think of the possibility of failure.
Robert Shiller told the story of Irving Fisher – a Yale professor in the early 20th century – who said that the stock market in 1929 was in “permanently high plateau.” He invested heavily in the stock market, but ended up losing a lot of money in the 1929 crash. Yale needed to buy his house and rented it out to him for him not to be on the street. Did he change his view after all that happened? No. He still insisted that he was right. He borrowed money from his wealthy relatives, invested it, and lost it all. 
So be prepared for failure. Doing so will help you recover quickly.
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