This time in my ”MTEA series” i reflect on the emotion confidence. Let’s start by looking what our friend Wikipedia states about it:

”Confidence is a state of being certain either that a hypothesis or prediction is correct or that a chosen course of action is the best or most effective. Confidence comes from a latin word fidere’ which means ”to trust”; therefore, having a self-confidence is having trust in one’s self.” (Wikipedia: ”confidence”)

I would add that confidence is typically tied to ”doing”. This is easier to explain with the help of self-confidence. One can develop a great self-confidence by doing things and succeed in that doing. For example i used to swim (in competitions) when i was a kid and when i practiced, i got better and i managed to improve my lap times and this contributed finally to better self-confidence. It is worth to point out, that good self-confidence doesn’t necessarely come hand in hand with good self-esteem. On the contrary, i have seen it in myself and in many other people, that one can have a combination of good self-confidence and poor self esteem. Self esteem is tied to ”being”: how do i feel about myself as a human being (not as a human doing).

Then, what are particularly interesting consepts in investment world are the ”derivatives of confidence” which are also called cognitive biases: over- and under-confidence. American Psychological Association’s dictionary defines those as:

Under-confidence: a cognitive bias characterized by an underestimation of one’s ability to perform a task successfully or by an underrating of one’s performance relative to that of others.

Over-confidence: a cognitive bias characterized by an overestimation of one’s actual ability to perform a task successfully, by a belief that one’s performance is better than that of others, or by excessive certainty in the accuracy of one’s beliefs.

Especially over-confidence is widely recognized bias in the capital markets. Probably the most famous researcher of overconfidence (among many other things) is the nobel-winner Daniel Kahnemann who has said about the bias:

• ”We are prone to overestimate how much we understand about the world and to underestimate the role of chance in events.”
• ”Declarations of high confidence mainly tell you that an individual has constructed a coherent story in his mind, not necessarily that the story is true.”

Furthermore, Larry Swedroe (from the ”evidence based investor” web page) summarizes some known characteristics regarding over-confidence that Kent Daniel and David Hirshleifer have written in their piece called ”Overconfident Investors, Predictable Returns, and Excessive Trading”: 

• ”People tend to be over-optimistic about their life prospects, and this optimism directly affects their final decisions.”
• ”Overconfidence has been documented among experts and professionals, including corporate financial officers as well as professional traders and investment bankers.”
• ”Overconfidence includes over-placement (over-estimation of one’s rank in a population on some positive dimension) and over-precision (over-estimation of the accuracy of one’s beliefs). An example is the overestimation of one’s ability to predict stock market returns.”
• ”A cognitive process that helps support overconfident beliefs is self-attribution bias — people credit their own talent and abilities for past successes while blaming their failures on bad luck. Self-attribution bias allows overconfidence to persist. When investors “get it right,” they upgrade their confidence in their beliefs; when they “get it wrong,” they fail to downgrade it.”
• ”Men are more overconfident than women in decision domains traditionally perceived as masculine, such as financial matters. Overconfidence leads to more trading. One study found that, consistent with higher confidence on the part of men, the average turnover for accounts opened by men is about 1.5 times higher than for accounts opened by women, and as a result, men pay almost one per cent per year more in higher transaction costs and their net-of-fee returns are far lower.”

To sum up, over-confidence is widely acknowledged phenomenom in the financial markets and it can sabotage one’s trading records. Under-confidence is not an optimal angle in investing – and in life in general – either. One bumps into under-confidence bias more in the self-help literature where all kinds of books try to help people getting more confidence. So we are easily getting mixed signals: are we too over- or underconfident? And is there some ”right amount of confidence” that i could try to target? PhD Don A. Moore says there is. He says:

• ”There is a zone between too much and not enough confidence. This Goldilocks zone of confidence is where rational beliefs meet reality.  It is fundamentally based on truth and good sense. It is built on beliefs that can be justified by evidence and honest self-examination. It steers between the perilous cliff of overconfidence and the quicksand of underconfidence. It is not always easy to find this narrow path; it takes honest self-reflection, level-headed analysis, and the courage to resist wishful thinking.”

and furthermore:

• ”This middle way is not the path to mediocrity—far from it.  It is exceptionally rare to be well-calibrated in one’s confidence. It requires that you understand yourself and what you are capable of achieving. It requires that you know your limitations and what opportunities are not worth pursuing. It requires that you act confidently based on what you know, even if it means taking a stand, making a bet, or speaking up for a viewpoint that is unpopular. But it also requires the willingness to consider the possibility that you are wrong, to listen to evidence, and to change your mind. This is a rare combination of courage and intellectual humility, which leads to actively open-minded thinking. It takes just the right amount of confidence.”

I wrap up this story by listing few things that i have found useful when working on my ”right amount of confidence”:

• try to work on your self-awareness and consciousness and in this case particularly regarding confidence: are you typically over- or underconfident; and in what areas of life these biases typically exist? It might be good to mirror that with supervisor/coach/therapist to get honest and professional reflection; one’s confidence level and biases are typically coloured by childhood experiences and that makes this phase difficult
• Once you are aware of your typical biases, you can start working to aim for optimal level of confidence. For example with your over-confidence you probably need to work with humility – ability to be more humble. That on the other hand requires more work with your vulnerability.
• Observations vs interpretations: are your thoughts based on observations or interpretations? It is useful skill to work making observations rather than projected interpretations. This helps you to make ”level headed analysis”. This process impacts your thinking which impacts on your emotions and behavior. The more you are able to make clean observations, the more likely you are also less biased to false over-confidence.  

So, confidence issue is pretty complex and multi faceted. Good thing is that it can be worked out and that might be very valuable investment for a trader, portfolio managers and others.

Aku