The Practice Effect – How to Minimize Overconfidence

All you need in this life is ignorance and confidence then success is sure.  Mark Twain

Overconfidence is one of the favorite biases of Behavioral Finance folks.  It goes a long way to help support their Irrational Market paradigm.

“People are overconfident. Psychologists have determined that overconfidence causes people to overestimate their knowledge, underestimate risks, and exaggerate their ability to control events. Does overconfidence occur in investment decision making? Security selection is a difficult task. It is precisely this type of task at which people exhibit the greatest overconfidence.”
Nofsinger (2001)

Overconfidence means that we generally tend to view the future prospects to be more favorable than they turn out to be and it also means that we tend to overestimate the likelihood of our predictions about the future being accurate.

Overconfidence is one of the most powerful forces that works against appropriate risk management.  The most overconfident feel that risk management is a total waste of time and money.  Why waste time and resources preparing for failure when you can spend that time and resources assuring success? they ask.

One way to reduce the power of overconfidence is Practice.  What you need to practice is estimating likelihoods.  And then tabulating the  results.  Regularly perform what actuaries call an actual to expected analysis.

The Practice Effect is what psychologists want to avoid when they are doing experiments.  They usually do not want folks getting better and better with repeated trials.  So they are always looking to introduce fresh folks.

But in business and especially risk management we need the Practice Effect.

Risk Management works with estimated distributions of likelihood of adverse events.  One simple way to practice is to look at each period’s experience in terms of the prior year’s estimated distribution.  Was last year a 99th percentile year or a 78th percentile year?  Each you everyone should be informed of that and everyone can form an opinion about how good that prior estimate of likelihood was.

Of course, the firms that look at each risk as a single frequency severity pair cannot do that.  One more reason why the single pair approach to risk assessment falls short of real usability.

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