Quantitative Risk Management: A Practical Guide to Financial Risk, + Website

2.5 The Curse of Overconfidence

Much of this chapter has been concerned with how our human intuition can be fooled by randomness and uncertainty. We have seen that it is easy to generate (random) runs and streaks that seem, intuitively, very nonrandom. Humans, however, crave control over their environment, and we will often impose an illusion of certainty and control over purely random events. It is all too easy, all too tempting, to mistake luck for skill, and the result can be overconfidence in our own abilities. There is a fundamental tension here because confidence in one's abilities is as necessary for successful performance in the financial arena as it is in any area of life, but overconfidence can also breed hubris, complacency, and an inability to recognize and adapt to new circumstances.

Gladwell (2009) wrote an interesting essay discussing the importance of psychology, in particular confidence and overconfidence, in the finance industry and in running an investment bank. He focuses specifically on Jimmy Cayne and the fall of Bear Stearns in 2008 (with interesting digressions to the debacle of Gallipoli). With hindsight, Cayne's words and actions can seem to be the purest hubris. But Gladwell argues, convincingly, that such confidence is a necessary component of running an investment bank. If those running the bank did not have such optimism and confidence, why would any customers or competitors have confidence in the bank? And yet such confidence can be maladaptive.