Confidence is a great gift. It can lead people to do amazing things, like invest in obscure companies poised for amazing gains or start new businesses altogether. However, overconfidence can ruin everything in investing decisions, and business decisions, too.
When confidence becomes nonsense
For investors, the psychological "overconfidence" hurdle is no joke, and data back up its dangers. A study conducted by Terrance Odean at the University of California at Berkeley pointed out that overconfidence in one's own investing acumen leads people to trade too frequently, stunting returns. In addition, Washington State University professor of finance John Nofsinger covered similar topics in The Psychology of Investing, pointing out many investors' tendencies to overestimate the accuracy of the data they have on hand and their own ability to use it properly.
I've seen one variety of overconfidence firsthand when I've talked about real risks for stocks with cult followings. In rationally bringing up concerns about Sirius XM (Nasdaq: SIRI ) , DryShips (Nasdaq: DRYS ) , and Crocs (Nasdaq: CROX ) , I've faced enraged readers and even personal insults. To decide to buy and hold such stocks while being aware of the risks is one thing, but refusing to acknowledge potential problems is foolhardy and dangerous.
Fundamentals like high debt levels, dwindling sales and profitability, competitive challenges, burgeoning inventory, and other completely factual data seem to matter not a whit to some types of investors, who may be way too confident about their investment theses. Soberly addressing very real risk helps avoid some terrible portfolio pitfalls.
Drinking the Kool-Aid, corporate-style
Overconfidence can indirectly hurt investors even when they're not the ones making the "overconfident" decisions. The time before the financial crisis showed what happens when business managers all "drink the Kool-Aid." Major problems ensued when too many folks at Citigroup (NYSE: C ) , Bank of America (NYSE: BAC ) , Goldman Sachs (NYSE: GS ) , and now-defunct Lehman Brothers truly seemed to believe the stratospheric rise in housing prices and the subprime lending that supported it were sustainable. Many of those companies' shareholders suffered greatly when the shoddy premises finally fell apart.
Back then, just about everybody was a little too overconfident that housing prices "could never go down," making everyone from corporate brass to individual real estate speculators feel like geniuses ... until they realized they weren't.
On the corporate governance front, corporate managers might be too overconfident, and so might boards of directors. Runaway executive compensation might include overconfidence about certain individuals' abilities; too many CEO contracts and pay policies always assume performance is or will be great, instead of safeguarding against any possible negative outcome. Golden parachutes should be the exception, not the rule, and too many CEOs get paid handsomely for poor performance for years on end.
Bizarre business decisions like the one to pay Abercrombie & Fitch (NYSE: ANF ) Chairman and CEO Mike Jeffries millions not to fly the corporate jet sound like overconfidence or overwhelming ego. Nobody thought shareholders might have a problem with that?
Psyched up or psyched out?
The marketplace has a very psychological component, and paying attention to the tendency to exhibit overconfidence might help us all make better investing, business, and life decisions. Being endowed with a reasonable level of confidence is one thing. Being certain nothing can ever go wrong, and allowing ourselves to be myopic to very real risks, is a recipe for disaster.
Check back at Fool.com every Wednesday and Friday for Alyce Lomax's columns on corporate governance.