Overconfidence, Recency, and Narrative Bias

Why this matters

The last lesson was about how we feel about gains and losses. This one is about how we judge what we know. All three biases here make a decision feel more certain than it is, which makes them dangerous in a field where almost nothing is certain.

Overconfidence

Overconfidence is being more sure of your judgment than the evidence supports. In investing, it often shows up as trading: if you're confident you know which stock will do better, switching feels smart.

Brad Barber and Terrance Odean tested this by comparing men and women, since psychological research suggests men tend to be more overconfident in areas such as finance. Using data from more than 35,000 households at a large discount brokerage, they found that men traded 45% more than women, and that trading reduced men's net returns by 2.65 percentage points a year, compared with 1.72 percentage points for women.¹ The lesson isn't about gender. It's that more confidence led to more trading, and more trading led to lower returns.

Overconfidence also makes people easier to defraud. The SEC-commissioned report on investor behavior notes research identifying overconfidence as a main psychological reason otherwise sophisticated investors fall for frauds.²

Recency bias

Recency bias is giving too much weight to what just happened. After a great year, it feels natural to expect another; after a bad one, to expect more pain. The data doesn't support either instinct.

After a year when stocks...	How many times	Average return the next year	Next year was a loss
Rose 25% or more	26	9.3%	9 times
Fell	26	13.1%	8 times
Any year	97	11.5%	26 times

S&P 500 yearly returns, including dividends, from Damodaran's data.³ Calculated for this lesson; "average" is the simple average of yearly returns. The correlation between one year's return and the next is about −0.02, essentially zero.

Great years weren't reliably followed by more great years, and losing years weren't reliably followed by more losses. An investor who piled in after strong years, or fled after weak ones, was acting on a pattern that didn't exist.

The rest of this lesson is for members

Still to come in this lesson: Narrative bias, Defenses, the key takeaways, and 2 quiz questions with explanations.

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