05.09.21

The overconfidence bias

The overconfidence bias is the tendency to overestimate our talents and abilities. We consider ourselves better than we really are.

Tom Matthews


The overconfidence bias is one of the biggest of all the biases of the human brain. You can spot overconfidence in others with ease but not your own. However, we are all far more vulnerable to overconfidence than we believe.

What is it?

The overconfidence bias is a tendency to hold a false and misleading assessment of our skills, intellect, or talent. In short, it’s an egotistical belief that we’re better than we actually are. It can be a dangerous bias and is very prolific in behavioural finance, capital markets and growth investing.

Types of overconfidence

The easiest way to get a thorough understanding of the overconfidence bias is to look at examples of how it plays out in the real world. Below is a list of the most common types of overconfidence biases and some specific situations where we often see it play out in the world of growth investing.

1. Overrating yourself:

Overrating is a type of overconfidence bias where people rate their performance higher than it really is. That means that we overestimate our abilities and think that we are better than we actually are.

For example, if you ask a room full of people if they believe themselves to be better than average drivers, studies have shown that over 90% will say they do. The same holds true in the field of investing – about 74% of professional investors think they are better than the average investor. Clearly these examples cannot be statistically correct. This mathematical impossibility is the result of the overconfidence bias.

The reality is that most people think of themselves as better than average. In business and investing, this can cause major problems because it typically leads to taking on too much risk.

In growth investing, we often see this type of overconfidence manifest itself in overly optimistic projections of where management believe they can take the target company to over the next 3-5 years.

To try to mitigate this overrating bias, at Pemba, we spend a lot of time sensitising management’s forecasts and understanding “what we need to believe” in order for the investment to achieve an underwriting case that generates our minimum return requirement.

The key assumptions in this underwriting case are set out into discrete hypotheses in our investment thesis that get tested through a thorough due diligence process.

2. Illusion of control:

The illusion of control bias occurs when people think they have control over a situation, when in fact they do not. On average, people believe they have more control than they really do. This, again, can be very dangerous in business and investing, as it leads us to think situations are less risky than they actually are. Failure to accurately assess risk leads to failure to adequately manage risk.

A good example of where we often see this illusion of control in growth investing, is many firms who invest in founder-led businesses that insist on taking a controlling stake and are not prepared to invest for minority positions. The reason for this is, these firms believe having a controlling equity stake makes it easier for them to effect change if things aren’t going to plan.

However, when investing in founder-led businesses, it’s very difficult to do anything without the support of the founder, regardless of whether or not you have a majority equity position.

For us at Pemba, there’s got to be consensus with the founder we are investing alongside (even if we hold the majority of the equity). It goes to our partnership style of investing – if we can’t build a strong enough case to convince the founder, then we don’t do it. If the founder isn’t convinced, then it’s probably not the right thing to do.

3. Unrealistic optimism:

In the third form of overconfidence, people believe they can complete a task faster than they actually can. This applies to many things, like learning a new skill, meeting a deadline, or estimating how long it will take you to prepare an investment committee paper. Unrealistic optimism is especially true for complicated tasks, business people constantly underestimate how long a project will take to complete. Likewise, investors frequently underestimate how long it may take for an investment to pay off.

To try to mitigate unrealistic optimism, at Pemba, our underwriting case (used to generate our minimum return requirement) always:

  • Is based off the core business on a standalone basis and therefore does not include the benefit of strategic, value-enhancing bolt on acquisitions. However, as a specialist “buy and build” investor, even before we have completed the initial “platform” investment, we will often have a clear buy and build strategy growth agreed with the founder and management team, setting out which complementary businesses we could partner with to accelerate the growth of the combined group and enhance equity value and returns for all shareholders
  • Assumes that our exit multiple is equal to our entry multiple for returns modelling purposes and never factors in any “multiple arbitrage”. However, given the accelerated growth of the business as a result of the founder bringing on board an experienced growth partner like Pemba and the benefits of a buy and build growth strategy, the size, scale and diversification of the business on exit often results in significant “multiple arbitrage”.

The result is that we often achieve an accelerated investment horizon for a number of our investments and returns far in excess of our underwriting case.

How to avoid the overconfidence bias

Luckily, there are a few things that can help you to avoid the pitfalls of the overconfidence bias.

First, you should always be your own devil’s advocate. Whenever you make a decision, ask yourself ‘what could go wrong?’. Think through what the “doomsday” scenario looks like and remind yourself how much it would hurt to lose some or all of that money you are investing.

Second, you should always do your own research. I can’t stress how important this is. Never blindly take advice from anyone when it comes to investing, not even the so-called experts. Always do your own research and due diligence and don’t just look to the views of those who support your opinion, rather deliberately seek out people that hold opposing views and see if they offer any valid points.

And finally, the third thing is to diversify your portfolio. Never put all your eggs in one basket. Picking individual winning assets consistently over time is virtually impossible, so you are better off diversifying your portfolio.

 

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