Delusion, illusion,

Illusions about ourself and our decisions,
in economic and financial behaviors

Overconfidence, the delusions about one's capabilities,
as well as under-confidence, are behavioral biases
that lead to wrong decisions in many life situations,
and among them in the economic and financial areas.

Illusions can be either individual or collective.

Feeling a bit above other mortals?
It might give some confidence.
But our mirror might tell lies.

Overconfidence, under-confidence and other delusions about one's
are behavioral biases based on incentive  false
beliefs about oneself (and to some extent about the external

They bring flawed decisions in many life situations, among
them when money is at stake,
such as economics and finance

A) Overconfidence bias

ego I'm the best gun in town. The best poker player, too.
   So how can I lose?
An overconfidence bias is seen when somebody puts
      an excessive trust in his own 
 judgments, predictions and abilities.
This leads to mental blind blindness and a risk of self'-
defeating decisions.

This can reach even the most professionnal "experts" who
rely so much on their intuition brought by a long experience that they
tend to believe in their infallibilty in making previsions and miss some
hidden factors

Also successful businessmen / corporate executive might go
"a bridge too far", with a costly venture or merger that neglect the
base rate probability of success of such projects (actually a rate
that is quite low).

They think their past successes show them as more competent than
the small fry (forgetting they might just have been lucky).
They get overoptimist about the gain prospects of their moves
compared to the risks, costs and difficulties.

1) How to be overconfident...or preferably not.

Actually, overconfidence is rather common in most aspects of life.
But some people are more overconfident than others.
On the other hand some are naturally under confident (see C section).

An overconfident person tends to
  • overestimate the chances of success of its actions (complacency),
  • underestimate the risks (and perverse effects) of its decision.
Overconfidence can result either
  * from hatchemerge inexperience
  * or from  ego self-admiration
     (and sometimes both!).

2) What does it leads to?
    Optimism? Haste? Sometimes laziness?

Overconfidence is a biased self-centered anticipation that can cause:
  • either over-optimism
that leads to take initiatives on apparently favorable situations,
while neglecting to explore all the pitfalls and drawbacks.
  • or over-pessimism,
that can lead to take no initiative, in a situation judged doomed
under one's own lofty "infallible" judgment, without exploring all its

But the opposite might sometimes occur:
inertia based on overoptimism and wild initiatives on over pessimism.

Same thing for overconfidence (you can be overconfident in your
judgment that things will turn bad) and under confidence.

Overconfidence can lead
   * either to rush into sillymad wild actions, overtrading for example,
   * or on the contrary to snail delay decisions about needed
3) Individual and group overconfidence

Overconfidence can be
individual or collective, narcissist or dependent

=> Either an individual attitude

For example, most car drivers consider their abilities as superior
to those
of the other members of the motorized crowd.

This shows a human narcissistic tendency that makes many people think
they are a
bit above other people. 

Or at least feel (see below "group contamination") that they belong to a
(elitism) with a
superior behavior and/or vision.

  • => Or a group groupcontamination (blinded by the crowd)

    People within a group (corporation, profession, organization, ethnic
    group, community,
    country) tend to be more confident than
    when they are alone
    They might also think that "their" group's abilities (and rights) are
    superior to those
    of other groups.

    Of course, union makes strength as a national motto says. But
    group overconfidence
    sometimes leads to extremes of arrogance,
    complacency and distrust of things / ideas / info coming from
    the outside
    ("not invented here").

    This neglects to take into account the external reality.

    And also sometimes it breeds an aversion to "strangers" (xenophobia,
    racism, parochialism...).
    Some under-confident / insecure people (see below
    "underconfidence") choose to belong to a strong-looking group.
    It might sadly explain the success of some cults or extremist
    political movements.

    A related phenomena is gullibility or dependence dependence
    created, not directly by a group, but by its leader or some
    other person that take control of the decider (guru, expert,
    On those phenomena see herd instinct and experts' power

    4) Overconfidence in management and in finance

    Overconfidence is notably present in business and financial decisions.
    Maybe it is a box luck for the whole economy  (well, except if
    it leads to extreme
    sillymad exuberance that erase any precaution), as
    without their fighting instinct,
    things would be at a standstill.

    A well known overconfidence effect is seen in
    project management,
    as many projects needs much more money, efforts, time than
    originally planned
    Bad surprises are the rule, pals, we were naive to expect that the
    world was on our side !

    Individual aspect

    The case of the overconfident businessman or CEO, conditionned by
    its own
    past successes that might just has been a matter of luck, was
    shown  above

    In investing, under- /over-confidence is about ones' own abilities to
    take the right buying or selling decisions, not about the direction
    market prospects
    wille take.

    For example, an investor can be pessimistic about the market and
    confident in his/her own ability to take advantage of it, playing on
    future, options or countercyclical assets.

    Most traders think they can beat the market.
    Overconfident investors / traders (and also borrowers, corporate
    managers, advisers...)
    overestimate their information (knowledge
    illusion), the accuracy of their estimates and their abilities (control
    illusion, experience illusion).

    => This may induce them to take undue risks and / or to overpay
             their prey and victory (winner's curse).

    It is often a factor in buysell overtrading, under the idea by some
    overconfident traders that most of the moves they make will be the
    right ones.

    Collective aspect

    Some social mood theorists link market rises and falls to "waves" of
    collective over- and under-confidence
    that foster exaggerated
    optimism or pessimism.

    This approach is partly true as
    a streak of luck, by following the
    crowd could fuel overconfidence (see attribution) and lead to take
    more and more frequent, large and risky bets.

    Obviously, no surprise here, overconfidence reaches more and more
    people in
    bubble  bullish markets.
    About every investor feels lucky or smart in such an exuberant situation.
    He thinks he will be able to find in time a less smart one, a "greater fool"
    to sell him the burning log.

    This makes him keep his assets for too long, and even to buy new ones,
    even when he is warned that they got grossly overpriced.

    => This behavior sustains and develops price bubbles.

    Also, any outside event that creates a "feel good" sentiment, even
    if it has nothing to do with economy and finance, can boost confidence,


    B) Self-delusions linked to overconfidence

    (Genius inside)

    Now come the incentive false beliefs about one's capacities.
    They are found among most deciders, which means about anybody.
    Those delusions show two sides:
    • Illusion of competence, experience and knowledge,
    • Illusion of control on outside events.

    Origins of illusions

    What is missing? What is too much?

    Those personal (or collective) illusions might have various origins,

    * cognitive
       (misunderstanding, flawed memory)
    * or emotional

       (attempt at compensating earlier pains
       or following earlier pleasures).

    Let us quote a few more precise ones.
    • An distortasymm imbalance, one way or the other,
    between the person's (or the group's) formal learning
    and its practical experience.
    They are usually both needed and each one reinforces the
    When one side, either learning or practice, is too light, the
    boat is in danger !

    • Some mental sleep laziness
    that prevents also to dig deeper, thinking we know enough
    or understand enough (see availability heuristic),
    • A recent streak of prior win successes.
    Here, if we take asset markets as examples :
    A successful player can get a wrong feeling of infallibility
    even if its successes come only from pure luck,
    or to the simple
    fact that
    the economy
    became favorable to their venture or
    the financial market was bullish and nearly everybody made

    • Conversely, if things turn bad, a trader might attribute it to bad luck.
    It will neglect to examine things further to detect if it made
    mistakes and correct them in the future.
    • Some ingrained or long developed ego narcissist tendency 
  • (feeling to be above other human beings and to be entitled to
    all rights
    upon them and upon the world itself, the "master
    of the universe" syndrome),
    as already mentioned.
    • A belief that bulbintuition or instinct is enough
    for wise decisions whatever the uncertainties (pseudo-
  • certainty)
    • magic Magical thinking, illusion of control" (see article below).
    A belief that things can only turn right as the person is
  • born under a lucky star. Here we are not far from
  • narcissism. But also it might be just a "wish to believe",
  • whatever its dangers, to find some comfort when
  • facing uncertainty or hardship.

  • Not to forget illusions coming from ...outside manipulato
      (poach fraud, dependence  domination...)

    Illusion is worse than ignorance

    Is incompetence not enough?

  • Does illusion upgrade ordinary incompetence to perfect incompetence?
    Ignorance, inexperience or incompetence are in themselves obstacles to
    decide soundly.

    But illusions make it worse. 

    Things get graver when the decider believes he has no deficiency.
    Normally, to know what we lack help us to find ways to compensate (*)
    such flaws.

    On the contrary, the illusive belief or feeling that we are fit paralyzes any
    to correct what is lacking to make a sound decision.

    "The enemy of knowledge is not ignorance but the illusion
    of knowledge"

    Same thing for competence, experience...

    (*) Of course, when the lack of time or means cannot be compensated, 
          and to choose
    a course of actions is anyway needed, it might be better
    improvise a move than staying passive.
          But with the provision that the decider knows its limitations.

    Those self-illusions lead the player at the same time to underestimate
    the difficulties
    of the situation and to overestimate its own abilities.

    Those beliefs (or just a lack of conscious appraisal) are among the
    ingredients of dangerous
    biases such as overconfidence (as detailed
    in the above chapter), self admiration,
    narcissism and /or magical

    Shared illusions (let us dream together)

    Not only people can have self-illusion, but groups, crowds and
    societies also are prone to it and can easily become blind
    and arrogant

    People often find within groups an impression of strength, certainty
    and safety against
    the outside world.
    There might some reality in how groups are a support for individuals,
    but it can be also only apparent and lead them to abandon some of
    their personality and lucidity

    B+) Types of illusions

    1) Illusion of competence, experience, knowledge

    Mister Know it all.

    The (self-) illusion of competence, experience, knowledge is
    a mental bias that makes
    people overestimate their ability and

    This exaggerated reliance in their capabilities leads them to make
    highly risky decisions.

    2) Illusion of control

    The illusion of control is a conscious or unconscious belief close to
    thinking and narcissism.

    It makes people think / feel that things can only turn right for them,
    that they were
    born under a good star, that luck is on their side and
    the gods in their hands, that
    they have the mental capacity to
    influence events
    and to run the show. 

    Maybe a way for them not to feel the anguish of uncertainty.

    Like the illusion of competence it can lead to overly risky decisions
    (for ex. 
    in investment, to concentrate a big stake on only a few stocks).

    Also, when the outcome is unfavorable, in can make neglect to analyze
    why things
    went wrong so as to avoid the same mistakes, by attributing
    the failure to an occasional
    luck reversal.

    3) Anecdotal market example: the greater fool delusion

    Gullibility, illusions and delusions are frequent in asset
    , for example stock markets.

    A typical one is the
    greater fool delusion

    It is for an investor / trader to buy an extremely overpriced asset,
    after a long price uptrend
    that lead to blatantly overpriced assets
    compared to any rational valuation criterion, with
    the idea that
    greater fool will buy it later at an even higher price, before the
    music stops and the price crashes down.

    It might work, but that (extended) "trend following" tactic has also
    a good chance to be found delusively that trader: the torrent of
    greater fools might dry up very soon and the greater fool could
    be himself.

    C) Under confidence bias

    Afraid to be wrong and unable to choose between
    the bucket of water or the bale of hay.

    People might be underconf under-confident in their possible
    (compared to what they deem to be a good result).

    Effects of underconfidence

    When it freeze freezes decision

    Underconfidence tends to make people, and among them investors,
    freeze decisions
    (delaying tactics, status quo bias...).

    ecause of under-confidence, investors often procrastinate
    when they
    face events that change the prospects.
    They delay the needed action (buying, selling...).

    This translates into an under-reaction in market prices.

    Far from being immediate, price adjustments take place fully only
    later and gradually.

    Later overconfidence kicks in and investors rush to the new price
    The whole chain is seen as the main explanation of
    market momentums / trends,

    which are the most striking
    market anomalies

    When it leads to aping mimicry
    In some cases, under-confidence makes investor easily influenced by
    other people advices
    without checking by themselves if the advice is
    sound or if they can be trusted. 

    Under-confidence can also be one of the factors that feeds the
    herd instinct.

    It should not be confused with pessimism
    (or optimism)

    As under / over confidence is about ones' own abilities,

    it does not necessarily entail pessimism or optimism about market
    You can be certain or uncertain that your pessimism
    or optimism is right or
    wrong in the present market situation,
    just choose your option ;-)

    On the other hand, as said in the "overconfidence" section market rises
    and falls
    are sometimes attributed to waves of collective over / under-
    confidence, leading
    to general optimism or pessimism.
    Here is a contribution of Jan Kenneth Sorensen in the Behavioral-finance group
    that gives us a matrix that combines over / underconfidence with optimism /

    1 Overconfidence and optimism
    The classic popular notion of being in a boom. I think of a gold rush.

    2. Overconfidence and pessimism
    Being sure that conditions will only be worse and the good times are gone
    for good.
    My favorite example Ron Paul holding almost all of his wealth in gold.
    Completely selling short would be another example; I have no doubt that some
    people have done it and were wiped out by prosperity.

    3. Underconfidence and optimism
    Not too difficult to imagine.
    In financial investing, better results than you expected are wonderful. But not
    capitalizing on it (selling too soon or not investing in the first place) is very
    In real investment, under investing in productive capacity (both physical
    capital goods and infrastructure and intangibles such as R&D) would be
    source of later shortage.

    4. Underconfidence and pessimism
    It is more difficult for me to imagine. I think it expresses itself in a desire for
    Perhaps a flight to quality also reflects it, such as re allocating a portfolio to
    blue chip stocks or bonds.

    Reference and further readings

    Find more details on those biases in the
        Behavioral finance glossary
    and more specifically in the
         overconfidence and illusion pages.

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