Overconfidence Bias: Impact on Financial Decision Making
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1. Introduction - Analyzing Behavioral Biases in Academic Assignments
Behavioral bias can be denoted as an irrational belief that has the potency to influence unconsciously on the decision making process. The presence of various kinds of cognitive biases not only makes the process of decision-making complex but also leads to taking missteps. In the context of critically evaluating the behavioral bias and its impact on decision making, the overconfidence bias has been objectified here. The current essay encompasses the development of a logical structure with the help of various financial models in relation to selected behavioral bias. In addition, the essay also going to reflect on the intervention of policies that is accountable for the reduction of bias’s impact.
2. Description
Overconfidence is one of the prevalent and universal cognitive biases that greatly affected the decision-making process of individuals. It can be stated that every individual uses some mental shortcuts in the way of taking decisions. The presence of such a heuristic can create biased individuals' judgment and in turn, lead the individual to make ineffective steps regarding their decisions. As opined by Baddeley (2018), overconfidence bias is a tendency to overlook the other opinion and see ourselves as far better than others. Thereby it can be stated that the bias accelerates the individuals over-estimate and pave the way for rash decision formation.
The holding of a false egoistic belief is act as a dangerous constraint for financial investments. As per the AAA survey, 73% of Americans are suffered from such bias and take ill-advised attempts in their investment process (Han et al. 2022). It can be further stated that overconfidence bias tricks the individual's brain into believing that by taking risky bets the consistent beating can be possible in the market. Beyond that, the selected bias can be countered in various ways through having control over the over esteem. Over ranking is one of the prominent examples of such bias that triggers major investing risks in the area of making decisions on finances (Hamilton et al. 2019). Philanthropy behind this overconfidence psychology includes timing optimism and constantly underestimating the other's ability. Illusion regarding self-control is another potential reason behind the development of such cognitive bias among individuals.
On average, people have the belief that they have effective control over their investing but the lack of accuracy in risks analysis put them into the zone of such cognitive bias and also created an adverse effect on personal psychology. It has been also seen that sometimes individuals are overestimated the fact that something odds happened due to the bring out of desirable outcomes, which is commonly denoted as wishful thinking but just because of this overestimated mistake they have to face bias in their decision-making process. Furthermore, the bias that is occurred from overconfidence is basically insidious due to the inflation of social and emotional factors. As opined by Oyibo and Gabriel (2020), emotional and social distortion is contributed to the creation of cognitive bias, called overconfidence, which is the form of unavoidable accompaniment to success. Perhaps, the taking of various incentives from the individual level can help to overcome such bias in the area of decision making, especially in finances.
In 2011, Daniel Kahneman first documented this cognitive bias in his book and in the way of briefing stated that the bias is a significant one and leads to ethical constrain (Hallsworth et al. 2018). Some stereotypes beliefs are also there in the way of raising such bias. The evolution of overconfidence bias has been seen among the populations in a wide range with the evolutionary stability of confident populations. It remains prevalent in today's era and emerged the changing of the curve of market dynamics regarding the economy. Besides that, in the context of relevance in the policymaking, overconfidence bias greatly accelerates the individual's estimations and overseas disregard data and expert advice that adversely affected the decision-making process. As per the study of Liu et al. (2019), it can be stated that overconfidence potentially has been regulated the policy framing of product manufacturing. It has been seen that overconfidence makes the manufacturer in order to produce green products more than rational production and this overestimation has resulted in a higher deviation of greenness than over precision. Apart from that, it has been also seen that cognitive biases have made the real profit of the green manufacturer less than their optimal profit regarding the rational manufacturer (Sahu et al. 2020). Moreover, it can be stated that, as the existence of overconfidence bias regulates the emotional insights of the individuals thereby it has a direct impact on the framing of an effective decision in relation to financial investment and also possesses relevancy in policy-making.
3. Critical evaluation
3.1 Explanation of bias relation with the standard model and neo-classical models of decision making
Every individual is posses with certain financial goals in each phase of their life. It has been evident that the investing behavior of individuals is extensively influenced by Overconfidence bias and hinders their investment decisions. As per the theory of the “Expected utility model”, individuals must need to make a decision in relation to the expected utility hypothesis (Mishra et al. 2021). The theory also helps to theorize the scenario in which one individual naturally makes a decision without being aware of its outcomes. As opined by Valaskova et al. (2019), the theory is a predictive one that provides guidance to the people in terms of making decisions regarding classical economies. The model also takes into account the individual characteristics of decision making that are mainly risk-averse. Individuals should make decisions after utilizing each of the possible outcomes related to the decision or surroundings in which the utility of the outcomes measures help to weight the probability of preferred outcomes or alternatives.
This act helps the individuals in terms of having control over their emotion and pushes them to reconsider the decision that in turn contributes to the building of a rational decision. According to Zahera and Bansal (2018), by making a rational decision one can able to foster the decision's efficacy and mitigation of the bias in the form of overconfidence. It has been seen that individuals in their way of decision making refuse to be a fair gamble and risk aversion greatly implies in their utility functions as a result of having overconfidence bias. Thereby it can be stated that the concept of the utility is correlated with the outlining discrepancy of cognitive biases in the form of overconfidence. As per the various views, the overconfidence as a form of risk attitude is directly co-related with the curvatures of the various utility functions in the way of decision making that ultimately result in a poor decision in the various aspect of finance.
On the other hand, the utility theory also states that the higher the utility, the better the accurate action (Ruggeri et al. 2020). It also suggests developing a way of ranking the individual's actions as per their worthiness that may help to broaden the scope of utilizing all the possible insights in the path of decision making. By taking the approach of expected utility one can best address the outcomes of decisions that suppress the formation of any false expectation or over precision.
As per the “neo-classical model”, the organizational investment level should be varied upon its perceived opportunities of investment that are measured by Tobin's q. It also states that consumers' preferences are basically invariant in respect of current consumption or endowment. The theory also includes some assumptions that include the decisions on economic issues should always make taking a rational way through accessing full information regarding its usefulness (Szczepa?ski, 2018). It helps the business firms effectively handle their economic losses and get full advantages of economic success respectively. On the other hand, the theory propounded the investment decisions as to the combination of three factors such as technology, labour and capital, where equilibrium among individualism and rationality in the formation of decision is essential for its preferred outcomes. So, it can be stated that individuals need to take their economic decision by promoting a realistic view of their outcomes.
The other assumption of this model includes that, consumers generally compare the products and then take the decision of purchasing on the basis of perceived utility. Their main objective is to satisfactions capitalization by the use of the product or services. As opined by Guenzel and Malmendier, (2020), the theory also addresses that economic choice is most of the time based on the likelihood of the economic option that turns out the decision, as valuable for the future. Thereby it can be stated that in the area of decision making rationality is the prime parameter that suppresses the act of over esteem and also ensures the efficacy of decisions for the purposes in a possible way. In addition, the various studies also claimed that the cognitive bias is built on the premises of a lack of rational choices or the ability to utilize all the possible exponential in the path of decision building.
3.2 Impact of the bias on individual decision making
Overconfidence bias can be exhibited when the individuals rely on their own estimations rather than the surrounding facts. It can be stated that the bias of overconfidence does not necessarily refer to the individual's self-esteem but rather it relies on the individual's knowledge and the way of their thinking. As opined by Nofsinger et al. (2018), the selected bias can push the individuals to experience dangerous situations that are equipped to handle. Various forms of this bias affected the cognitive action of the individuals and result in the making of poor decisions. It has been seen that overestimation provides individuals with a sense of direction that includes ego centric behaviors regarding choosing the appropriate choice in decision making. On the other hand, the taking palace of over placement as a bias of overconfidence pushes the individuals to think that they are superior in comparison to others. These erroneous behaviors exhibit the credential of overconfidence and ultimately result in the creation of ineffective decisions.
It has been also seen that the form of over precision is quite common for individuals and thereby individuals experience the worst result. A person with overly confident behaviors easily neglects the surrounding oversees and therefore taking suitable decisions has become complex for them. As opined by Raveendra et al. (2018), behavioral biases resulted in cognitive errors in the individual's way that lead to the formation of sub-optimal decisions. Distinct changes in the brain's activity are also evident for the emotions promoting withdrawal avoidance that anticipate the effect of anxiety in the decision taking time and make the decision riskier simultaneously. It can be stated that individuals at the starting point of the making judgment estimate some range of outcomes and if this plausible phenomenon remains close to the outcomes of the final stage then there is a scope of generation of overconfidence among the individuals (Mukherji, 2019). Furthermore, the consideration of a narrow set of judgments is another reason behind the occurrence of overconfidence among the individuals and in the way of making the decision this heuristic concept potentially created bias. Moreover, due to cognitive bias, individuals are not able to take benefit from their expected outcomes that in turn affected their psychological well beings as well.
3.3 The implication of the bias in the area of financial decision making
The bias of overconfidence has a significant impact on the decision making especially in the area of finance. Decisions are the key parameter for the investment economy and for individual investors as well. For the context of market investors, the presence of accuracy in the investment decision is essential in terms of safeguarding mispricing and return variability. According to Bishop and Gagne (2018), the selected bias is pervasive and documented various judgmental errors in the way of decision making. The bias of overconfidence is an observed phenomenon in the financial market that makes the investors grab the risky opportunities due to the illusion of control that in turn leads to the financial loss. Apart from that, it has been evident that in time of market distress such as price bubbles, market anomalies and others, due to this cognitive bias similar kind of movement among individuals' decisions has been noticed that greatly lead to substantial losses of welfare.
On the other hand, it is the ordinary nature of the individuals that their judgment building primarily relies on the first piece of information. It has been seen that investors are likely to analyze their stock by taking a behavioral uncertainty that made the traders heuristic in terms of predicting the necessary decisions. Furthermore, due to the existence of overconfidence, the investors tend to neglect their own persistence and capabilities and give much focus on market trends or engage themselves in making comparisons with others (Posen et al. 2018). Various studies also indicated that excessive trading is a real example of an overconfidence bias effect among investors. It can also state that the traits of overconfidence regulate the market depth, enhanced the expectation regarding the trading volume and suppresses the utility of the traders. In addition, the investors, who experienced overconfidence bias, can cause the economic market to under react to the data of rational traders.
Due to the failure to take effective decisions investors have to deal with bad bets that in turn make the market more volatile for new traders. The frequently trading due to overconfidence bias leads to enhance the trading volumes in a massive that also negatively affected the market curve (Greenberg and Hershfield, 2019). Another high observed bias in regard to overconfident includes ignorance of trading skills that in turn results in mispricing of services or products in the financial market. Additionally, the manifestation of various behavioral abnormalities makes the domain of gain convex and increases the chance of loss due to poor decisions. Moreover, in this rational world, investors take their financial decisions in order to maximize their trade-off of risk-return. But due to overconfidence bias, they make their choices by overlooking the possibilities that in turn affected the equilibrium of return and risk. In order to deal with the several psychological errors in the decision-making way, rational behaviors are firmly needed.
3.4 Explanation of alternative model’s accountability with the bias
The prevalence of overconfidence bias exhibits various cognitive errors that make the decision ineffective for the implementation. As per the “Cumulative Prospect Theory”, individuals possess a tendency to first think of the possible outcomes usually to a certain point of the decision making rather than, give focus on the final status that is known as the effects of framing. It has been seen that, due to overconfidence, people tend to oversee the small probabilities as they believe they are logical in that way, that greatly created a negative impact on their decisions and ultimately makes their legal choice ineffective. The theory also includes the various risk attributes in order to gain in the process of reference point and losses that is below the reference point (Han et al. 2022). Thereby it has been seen that people are overweighed the extreme events rather than average events in their way of decision making.
The theory of prospect also describes the way of perceived likelihood among the chosen options that are focused on prospects and their estimation. Furthermore, the theory is used in various ranges of situations that appear economically inconsistent and possess the endowment effect. As opined by Kremer et al. (2019), this theory of prospect indicates that decisions should be based on the options that they rest on the biased judgment effectively. The framing effect helps to demonstrate the characteristic of the individuals in terms of their decision-making insights. By taking this alternative approach one can able to have control of their emotions in the path of accessing the possible utilities that in turn helps to make the decision more effective.
3.5 Policy’s intervention to reduce the impact of the bias
Behavioral biases can be subjected in a number of ways that include the encouragement of practicing the making of rational choices in terms of having control over the decisions. Apart from that, the use of the “wisdom of the crowd” can be another effective intervention for the purpose of reducing the impact of cognitive bias in the form of overconfidence. The approach involves the collection of the possible quos or guesses in terms of underlying the framing of the best decision for the individuals (Nikoli?, 2018). On the other hand, as per the nudge theory, the designing of the choices needs to rely on the individual thinking capacity and the decision should be based on instinct in order to retain its rationality. The theory also focused on introducing various techniques in order to enforce the necessary changes that include playing various games, in terms of joining the gym using the stairs and others.
Apart from that, the theory also offers a methodology for analyzing, identifying and reshaping the existing choices in terms of expanding their opportunities for success. Besides those other strategies in terms of reducing the bias impact such as the Kruger effect can be another effective one that includes being aware of the starting point along with the form of learning (Costa et al. 2019). Individuals in terms of giving extra care to their information collection process can able to foster the cognitive stability and able to establish an ethical decision respectively. Furthermore, fast decisions sometimes come with a biased one thereby the process of decision making should incorporate effective time for accelerating the potential assessment. Despite uncertainty in the circumstances or financial market, individuals need to have an idea in terms of when to take consideration and when confidence, which may help to extract a rational decision that is not driven by the egoistic aspect. Moreover, the approach of nudges helps to intervene in the individual approach of decision making and foster its rationality respectively.
4. Conclusion
On the whole, from the above discussion, it can be stated that behavioral bias effectively regulated the individual's ability to make the appropriate decisions in the area of their fiancé and others. Investors have been affected much in terms of the prevalence of such biases and doing bad bets in the marketplace that in turn affected the trading volume and created a paradigm shift in the market framework that affected the new investors effectively. Moreover, by taking a rational approach in terms of using the possible information in the way of judging one can able to reduce the adverse impact of these biases in the path of making decisions respectively.
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