Ask a room full of people whether they are above-average drivers, and roughly nine in ten hands go up.
This cannot be true. “Average” is the line with half of everyone below it. By definition, a large chunk of that confident room is wrong about themselves. They are not lying. They genuinely believe it. And the exact same thing happens when you ask people whether they are above-average investors.
Marcus, a friend who works in tech and reads the financial press every morning, was certain he could spot good companies before the market did. For two years he traded actively, buying what looked promising, selling what looked tired. He felt sharp and engaged the whole time. When he finally compared his results to what a boring, do-nothing index fund would have returned over the same period, he had underperformed it, before even counting the time he had spent.
He was not unlucky. He was overconfident, and overconfidence has a price list.
Confidence that outruns the evidence
Overconfidence is not the same as confidence. Confidence calibrated to reality is useful. Overconfidence is confidence that has run ahead of the evidence, and it is one of the most consistent findings in psychology. We overrate our abilities, overrate how much we know, and overrate how favourably luck will treat us specifically.
In money this is expensive in three recurring ways.
Too much trading. Each trade is a quiet bet that you know something the person on the other side of it does not. Usually you do not. Research by Brad Barber and Terrance Odean on thousands of accounts found that the most active traders earned the lowest net returns, dragged down by costs and by the very overconfidence that made them trade. Marcus, exactly.
Too little diversification. Overconfidence whispers that you do not need to spread your bets, because you can see which one will win. So people concentrate, putting too much into one company, often their employer, or one hot sector. When the concentrated bet works, it confirms the overconfidence. When it fails, it takes an outsized chunk with it. Diversification is, in part, an admission that you cannot reliably pick the winner, which is exactly the admission overconfidence resists.
Mistaking a rising market for skill. When everything goes up, everyone feels like a genius. It is easy to read a good few years as proof of talent rather than a tide lifting all boats. The bill for that confusion arrives in the next downturn.
The planning fallacy: the smooth-path assumption
Overconfidence has a quieter cousin that ambushes plans rather than portfolios.
The planning fallacy, documented by Kahneman and Tversky, is our reliable habit of underestimating how long things will take, how much they will cost, and how hard they will be, even for tasks we have done before and watched run over. Renovations, work projects, the time to write almost anything. We picture the version where everything goes smoothly, because that is the version that comes to mind, and the smooth version is almost never the one that happens.
The money version is everywhere:
- “I’ll start saving seriously next year, once I’m earning more.” The raise arrives; so do new expenses; the saving does not.
- “This side project will be profitable in six months.” It takes two years, if ever.
- “I’ll have the mortgage paid off early, no problem.” Life intervenes.
Each of these forecasts from inside the plan, where the path looks clear. The trouble is that life keeps adding the obstacles you did not picture.
The fix: borrow the outside view
Kahneman’s answer to both overconfidence and the planning fallacy is the same, and it is beautifully simple. Stop forecasting from inside your own plan. Step outside it and ask how things like this usually go.
This is the difference between the inside view and the outside view.
- Inside view: “My savings plan will work because I’ve thought it through and I’m committed.” Optimistic, because you are imagining the smooth path.
- Outside view: “How often do savings plans like mine actually survive a normal year of surprises? What share of active traders beat the index? How much do renovations like this typically overrun?” Then use those base rates as your anchor, and adjust your own estimate toward them.
The outside view feels deflating, which is exactly why it works. It drags your forecast back from the flattering story toward the unflattering record. In practice it means a handful of concrete habits:
- Set conservative assumptions. When you build a projection, lean toward the cautious end of return and timeline estimates. If reality beats them, lovely. If it does not, your plan still holds. A plan that only works in the smooth-path scenario is a wish in disguise.
- Diversify instead of concentrating. Treat diversification as a deliberate admission that you cannot reliably pick the winner. That admission is not weakness; it is calibration.
- Trade less. Once you have a sound, diversified allocation, activity tends to subtract value rather than add it. The boring choice of leaving it alone usually beats the confident choice of tinkering.
- Build in a margin of safety. Assume projects run long and cost more, because the base rates say they do. A buffer is not pessimism. It is what the track record recommends.
What you can do
- Run the driver test on yourself. Before any confident financial move, ask honestly whether you are relying on being above average. If half of all people doing this cannot be, what makes you the half that is?
- Switch to the outside view. For any plan or bet, find the base rate. How do projects, trades, or timelines like this usually turn out? Anchor on that record, not on your own story.
- Make your assumptions conservative on purpose. When you project savings or returns, choose numbers you would still be comfortable with if the next few years disappoint. Pleasant surprises are easy to absorb; unpleasant ones break optimistic plans.
- Do less. If you find yourself trading or tinkering to feel in control, recognise the urge for what it is. A diversified plan left alone usually outperforms a clever plan fussed over.
Overconfidence is about misjudging your own skill and luck. The next bias is about how easily your judgement gets swayed by something outside you entirely: the way a choice is worded and the first number you happen to see. That is framing and anchoring, and it is where we go next.