Explanation
Overconfidence bias refers to investors' tendency to overestimate their knowledge, skills, and ability to predict market movements. This bias leads to several behavioral consequences:
Why option C is correct:
- Poor diversification: Overconfident investors believe they can pick winning stocks or time the market, leading them to hold concentrated portfolios rather than well-diversified ones.
- Excessive trading: Overconfidence often results in higher trading frequency as investors believe they have superior information or skills.
- Underestimation of risk: Overconfident investors typically underestimate the risks associated with their investments.
Why options A and B are incorrect:
- Option A (overestimates downside risks): This is more characteristic of loss aversion or pessimism bias, not overconfidence. Overconfident investors typically underestimate risks.
- Option B (underestimates expected returns): This contradicts overconfidence bias. Overconfident investors tend to overestimate their expected returns, believing they can achieve above-average performance.
Key characteristics of overconfidence bias:
- Excessive trading
- Poor diversification
- Underestimation of risk
- Overestimation of returns
- Illusion of control
- Self-attribution bias (attributing success to skill and failure to bad luck)
In behavioral finance, overconfidence is one of the most common biases affecting investor decision-making and often leads to suboptimal portfolio construction and performance.
