Explanation

Overconfidence bias refers to investors' tendency to overestimate their own abilities, knowledge, and predictive accuracy. This bias typically leads to several consequences:

1. Poor diversification: Overconfident investors believe they can pick winning stocks and time the market, so they tend to hold concentrated portfolios rather than well-diversified ones.

2. Excessive trading: Overconfident investors trade more frequently than is optimal, incurring higher transaction costs.

3. Underestimation of risks: They tend to underestimate risks rather than overestimate them.

4. Overestimation of returns: They typically overestimate expected returns rather than underestimate them.

Let's analyze each option:

A. Overestimates downside risks - This is incorrect. Overconfident investors typically UNDERESTIMATE risks, believing they have superior ability to manage or avoid them.

B. Underestimates expected returns - This is incorrect. Overconfident investors typically OVERESTIMATE expected returns, believing their stock picks will outperform the market.

C. Holds a poorly diversified portfolio - This is CORRECT. Overconfident investors believe they can identify superior investments, leading them to concentrate their portfolios in a few stocks they think will outperform, rather than diversifying properly.

Behavioral Finance Context: Overconfidence bias is one of the most well-documented behavioral biases in finance. Research shows that overconfident investors:

• Trade 45% more than average
• Earn returns 3.5% lower than the market
• Are more likely to hold undiversified portfolios

This question tests understanding of how specific behavioral biases manifest in investor behavior, which is crucial for the CFA curriculum's behavioral finance section.