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What do smart chess players and stupid criminals have in common?

At the doctor’s office the other day, my doctor was supposed to review some recent test results with me. Instead of explaining the test results to me however, she called someone else to consult and then shared to results of her conversation with me.

My husband felt more confident in her as a result.  His belief is that since she was honest in accepting her confusion about the results and since instead of cooking something up, she clarified her doubts with an expert, we can trust her diagnoses to be based on sound principles and facts.

Her behavior bothered me though. What kind of doctor needs to clarify her understanding with someone else before talking to the patient? Definitely not a good one right? My husband asked me whether I would have been happier if she just hid her uncertainty and bluffed her way through the conversation.

That got me thinking. What was I expecting? That she know everything under the sun? No. Actually I was expecting a little more confidence in her diagnosis. I associated confidence with competence, in other words an illusion of confidence.

There are two different ways we fall for the illusion of confidence – illusion of self-confidence and the illusion of confidence with others.

What do smart chess players and stupid criminals have in common?

Illusion of self-confidence.

Overconfidence

 

Social Psychologists Kruger and Dunning of Cornell University in their fascinating paper titled “Unskilled and Unaware of it” told the story of  McArthur Wheeler, who robbed two banks in Pittsburgh in 1995 without using a disguise. Surveillance camera footage showing him was broad casted on the evening news and he was arrested an hour later.

“When police later showed him the security footage, Mr. Wheeler started in incredulity. ‘But I wore the juice,’ he mumbled. Apparently, Mr. Wheeler was under the impression that rubbing one’s face with lemon juice rendered it invisible to videotape cameras.”

Ok. So that was a stupid criminal & he overestimated his skills, but this behavior is not limited to criminals. This paper came out in 1999, in the last decade several more studies have proven that we consistently tend to overestimate our capabilities.

More recently, Chabris and Simons (famous for their Invisible Gorilla experiments) conducted a study with Chess players at the World open in Philadelphia and U.S. Amateur Team Championship in Parsippany, NJ. The asked the players 2 questions, as they walked by on their way to/from the games – “What  is  your  most  recent  official chess rating?” and “What do you think your rating should be to reflect your true current strength?”.

The first question has an obvious answer. The players knew their rating. The second question resulted in more interesting answers. The rating system is a pretty accurate one, so the correct answer should have been close to their current rating.  What the authors saw, though, was that –

21% said the current rating reflecting their true strength.
4% thought they were overrated.
75% believed they were underrated.

They even followed up after a year just to make sure the question was not interpreted as a potential prediction of their rating. No, they still found that the players were overestimating their abilities.

We do too.

How is overconfidence relevant to personal finance

Ok. We overestimate a little, but why does it matter to anyone? It matters because it affects our financial decisions negatively. How many of us are confident we can beat the market :) ? Quite a few.

1) This overconfidence leads us to be badly prepared for the future. We have all heard of funny stories of 50-something people walking into a financial planner’s office asking when they can have their retirement party with only $100000 in their account.

In their book, “Why smart people make stupid mistakes”, Belsky & Gilovich talk about a study done by The International association of financial planning.

Overconfidence

83 percent of respondents with children under the age of 18 said they had a financial plan, and 75 percent expressed confidence in their long-term financial health. However, less than half said they were saving for their children’s education, and less than 10 percent described their financial plan as addressing basic issues such as investments, insurance and savings.

Being overconfident can make us think we are more prepared that we really are.

2) Overconfidence is not good for investing decisions either.

You might ignore diversification of your portfolio because of a tendency to invest too much in what you are familiar with and you believe you have the best funds and do not want to dilute them.

You might trade more often because you have confidence in your market timing skills. Time and again, it has been proven that for an average investor, active trading and market timing just don’t work.

3) Invest in home base. Remember Enron? People were overconfident that they knew more about the company because they worked there.

4) You may blame yourself too much. This might be a little counter intuitive but for me personally, this was the biggest effect of my overconfidence. When you are overconfident about something and fail, you may blame yourself too much for the outcome.

What can we do about it

  • To start with, we can accept that we don’t know everything under the sun. Only when we accept that will we be more willing to learn. According to me, the day we stop learning is the day we start to get old :) Ignorance more frequently begets confidence than does knowledge.
  • Have an accountability partner, someone you trust, won’t feel hurt hearing their criticism, to keep you in check. For example, one’s spouse or partner might be perfect for this. I might see something in my husband’s decision that he might have overlooked due to his over confidence and vice versa.
  • Write everything down, like an investment diary. I have seen that, for me, when I write my reasoning down on paper and make it as explicit as possible, I am forced to be a little more rational.
  • And finally, I might get some heat for this, but here goes - acknowledge the role of luck. Hard work is important but so is luck. Just because we got it right once doesn’t prove that we are good.

Overconfidence in other people’s skills

This is the mistake that I made with my doctor. I still feel a little uncomfortable, but logically thinking if she really was incompetent, she would have told me some technical BS and sent me on my way.

We are more trustworthy of people who appear confident. This has an even more drastic effect than making mistakes due our own over confidence.

Lets take investments. A lot of people follow Jim Cramer. I don’t watch him regularly, I just happened to catch his show when I was in a restaurant one day. His energy was totally addictive. It made me want go do something…umm…impressive. May be jump off a building or may be I had too much to drink on that day. The point is, he has that effect on a lot of people and people trust his advice.

I don’t know how good his advice is in general, but on that particular day, his advice was worthless. I know that because he was recommending that people buy my husband’s company’s stock. I seriously feel bad for people who followed his advice because they got ripped off.

The same idea applies to celebrities. We blindly follow a lot of their decisions because they “look” confident and we associate that with competency.

I have mentioned this a few times before, but its always worth repeating. No one cares about your money more than you do.  Never take anyone’s word at the face value. Definitely consider their opinion, but think with a rational mind about the logic behind their opinion and then decide based on your own evaluation.

Every good decision requires knowledge (facts, context and concepts) and meta knowledge (an understanding of our strengths, weaknesses and limits).

To know that we know what we know and that we do not know what we do not know, that is true knowledge – Confucius.

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