Overconfidence Bias and Its Cost in Investing

Overconfidence is a well-documented behavioural bias in finance – often described as an “illusion of control” where investors overestimate their ability to predict or influence market outcomes. This bias affects everyone from retail stock traders to professional fund managers. In the Indian context, rapid economic growth, digital access to markets, and recent bull runs have sometimes fuelled overconfidence among investors.

Both retail and institutional investors can fall prey to this, leading to misallocation of capital. For example, pouring funds into overhyped equities or chasing quick profits while underestimating risks. This article explores what overconfidence bias entails, how it manifests in Indian investing behaviour, the real and opportunity costs it imposes, and why the stability of Fixed Deposits (FDs) offers a valuable counterbalance. 

The goal is to ground our discussion in research, historical data, and observable trends – avoiding mere opinion – and to highlight how disciplined planning (including humble FDs) can mitigate the risks of overconfidence in investing.

What Is Overconfidence Bias?

Overconfidence bias is a cognitive error that leads individuals to overestimate their knowledge and abilities, especially in decision-making under uncertainty. In investing, an overconfident person might believe they have superior skill or insight, when in reality their success may be due to luck or market conditions. Psychologically, most people tend to think they are above-average in various domains, a statistical impossibility, which makes them susceptible to this bias.

This overconfidence often manifests as an inflated sense of control or unwarranted optimism. Investors start believing they can consistently beat the market, predict price movements, or pick “winning” stocks, despite the fact that markets are influenced by countless unpredictable factors. This misplaced confidence can lead to poor decision-making: examples include excessive trading, taking outsized risks, or ignoring warning signs. 

Studies have shown that overconfident investors tend to trade too frequently, incurring high transaction costs that drag down their returns. They may also hold under-diversified portfolios or double-down on risky bets, underestimating the probability of adverse outcomes.

Classic research by Barber and Odean (2000) found that individual investors who traded most actively (often due to overconfidence in their stock-picking) earned significantly lower returns than the market averages, after costs.

Manifestations in Indian Retail and Institutional Investing

1. Retail Investors

In India, the stock market’s allure – amplified by digital platforms and economic optimism – has drawn millions of first-time investors in recent years. This democratization of investing is a positive trend, but it has also bred overconfidence among many retail participants.

With easy-to-use trading apps and a surge of market influencers touting success stories, it’s common to see retail investors believe that beating the market is easy or just a matter of timing. Behavioural finance concepts like the illusion of control are clearly at play – for instance, newcomers who made quick profits in the 2020–2021 rally often attributed it to skill rather than luck, reinforcing overconfidence in their stock-picking abilities. This confidence can be fragile: when market conditions turn, many such investors realize the difficulty of consistent outperformance.
One observable pattern is excessive trading and speculation among overconfident retail investors. India’s markets saw a 400% rise in day-trading activity between FY2019 and FY2023, with the number of individuals doing intraday trades rocketing from about 1.5 million to 6.9 million in that period.

A Securities and Exchange Board of India (SEBI) study found that a majority of these active traders were young and from smaller cities – and unfortunately, most were losing money. About 70% of day traders in the equity segment incurred losses, with the proportion of loss-makers as high as 76% among traders under 30, and 80% for those executing 500+ trades a year. Loss-making traders tended to trade far more frequently than profitable traders, indicating that overconfidence-driven overtrading was damaging their performance.

Many retail investors, emboldened by a bull run or a few winning trades, engage in high turnover and even futures/options speculation, only to erode their capital through fees and mistakes. Overconfidence also shows up as herding and chasing hot tips – for example, piling into popular IPOs or trendy stocks because “everyone else is,” assuming one can’t go wrong if the crowd is right. This often happens in bull markets; a study on the Indian stock market found evidence that investors became especially overconfident during pre-crash periods (e.g. just before the 2008 global crash, or in the 2015–2020 rally), only to become more cautious after major corrections. Such cycles suggest that retail sentiment swings from euphoria to fear, with overconfidence peaking when things seem persistently good.

2. Institutional Investors

Professional money managers and institutional investors are not immune to overconfidence either. In fact, the bias can be just as costly at the institutional level, albeit in different ways. Fund managers, armed with research teams and complex models, may develop unwarranted faith in their forecasts or stock-picking prowess. This is reflected in the persistent difficulty of active funds beating the market. Over time, very few actively managed mutual funds consistently outperform their benchmarks, especially after fees.

In India, for example, many equity mutual funds focused on blue-chip stocks have often been outpaced by low-cost index funds that simply track the market. This underperformance may suggest that even seasoned professionals – with all their analysis – struggle to predict market winners year after year. Overconfidence at the institutional level might lead to concentrated bets on certain sectors or stocks (believing one has superior insight), or to low cash buffers because the manager is sure of forthcoming gains.

A cautionary tale is that of numerous star fund managers who delivered a few years of high returns and then faced heavy losses when their bets went wrong – a sign that skill was overestimated and risk underestimated. The “if the experts can’t do it, what makes you think you can?” lesson resonates here. Additionally, institutional overconfidence can contribute to market-wide effects: for instance, if many fund managers simultaneously become overconfident on India’s growth story, they might all overweight certain equity sectors, pumping valuations to unsustainable levels. Such mispricing and eventual correction hurt not just those managers’ funds but also the broader capital allocation in the economy.

The Role of FDs in a Balanced Portfolio

In investing, humility and discipline often trump hubris. One practical way to instil discipline and mitigate the risks of overconfidence is by ensuring a portion of your portfolio is in stable, guaranteed-return instruments – and in India, fixed deposits (FDs) are a prime example of such tools. FDs have long been a staple of Indian household finance, and for good reason.

They offer certainty and capital preservation: when you put money in a bank fixed deposit, you know exactly what return you will get (the interest rate is fixed upfront) and your principal is protected from market ups and downs. In fact, fixed deposits “offer stability – your principal stays safe no matter how the markets fluctuate”. This guaranteed, predictable nature of FDs provides a valuable counterbalance to volatile assets like stocks.

Let’s consider how FDs can help an investor prone to overconfidence: Suppose you are excited about the stock market and expect, say, 15% returns from equities. A prudent approach might be to still keep a chunk of your savings in FDs or other fixed-income instruments. Those FDs act as an anchor for your portfolio.

If your stock picks don’t perform as expected (or in a bad year when stocks might even decline), the interest from FDs ensures that not all your money is subject to the same risk. During market downturns or unforeseen events, the FD portion won’t lose value – it continues to earn interest and provide liquidity.

This can prevent panic-selling of stocks because you know some money is safely compounding. Moreover, FDs inculcate a form of financial discipline: they typically have lock-in periods or penalties for early withdrawal, nudging investors to stay invested for the term.

This discourages the kind of impulsive reallocation that overconfidence might cause. Instead of trying to time every rupee in and out of the market, an investor with FDs is effectively saying, “I’m securing a base return for part of my wealth, and I won’t fiddle with it.” That mentality can spill over into a more patient approach with other investments as well.

It’s worth noting that a vast majority of Indians intuitively recognize the value of safety. While this skew towards safe assets might be partly due to limited risk appetite or lack of awareness, it underscores how FDs serve as a cornerstone of financial planning.

Importantly, we should view FDs not as “competition” to equity investments but as complements. Equities can deliver higher long-term growth, but FDs offer stability and predictability. A portfolio that blends the two can achieve a superior risk-adjusted return than one that is 100% equity fuelled by overconfidence. For instance, even a 70% equity / 30% fixed-income mix can greatly soften the blow in a market crash and give the investor confidence to stay the course. Many advisors suggest that asset allocation (deciding the mix of safe vs. risky assets) is more crucial to long-term success than stock picking. Including fixed deposits or bonds is a key part of that allocation. FDs also suit specific goals in disciplined planning – e.g. parking the money for a child’s tuition due next year in an FD makes sense, rather than risking it in stocks for a potentially small extra gain. By guaranteeing that funds for critical goals won’t evaporate, FDs enforce prudence.