People tend to overestimate their abilities – in financial knowledge, work performance, driving skills and many other fields. Ola Svenson’s 1981 study, “Are we all less risky and more skilful than our fellow drivers?”, found that 88 per cent of motorists rated themselves as above average. Similar self-assessments have been observed among engineers and university professors.
As a finance lecturer for the past 13 years, I’ve engaged in many conversations with my students, covering topics such as their trading successes, the swift accumulation of profits, trendy investments in cryptocurrencies and ambitious plans to retire at the modest age of 45, relying on passive income. This raises a couple of questions: are my finance students overconfident? And could this result in costly mistakes in their personal and future professional lives?
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Why should a business school concern itself with the concept of financial overconfidence?
Overconfidence can be costly. On a personal level, it leads to excessive borrowing, inadequate retirement planning and high-risk investments that increase the likelihood of losing your savings. Putting all your financial resources in one basket is a precarious strategy.
Equally concerning is the potential impact on professional financial advice. Overconfident financial professionals might inadequately manage the risks for their clients. Business schools should bear in mind the adage “prevention is better than cure” and highlight these concerns for their students.
Initiate the overconfidence discussion in class
The natural setting to address overconfidence is within the context of behavioural finance, a key component of many finance courses. This subject delves into the concept of overconfidence bias, offering an ideal opportunity to engage students in a thought-provoking seminar. You can use a simple four-question test to assess their overconfidence, challenging them to compare their perceived financial proficiency with their actual knowledge.
Step 1: Subjective assessment
Ask your students to rate their financial management abilities on a scale of one to seven. This serves as an indicator of their subjective financial literacy. For an interactive twist, consider using tools such as Mentimeter or Poll Everywhere to collect their responses, which can be visually represented as a bar chart in front of the class.
Step 2: Analyse subjective ratings
Once the ratings are revealed, you’ll probably observe a statistical trend in which most students rate themselves as a five or higher. Of course, statistics teach us that the majority cannot be above average. This realisation can lead to a stimulating discussion.
Step 3: Objective knowledge assessment
Assess your students’ objective financial knowledge. You can start with the “Big 3” test developed by Annamaria Lusardi and Olivia S. Mitchell in “Financial literacy around the world: an overview”, which presents multiple-choice questions on interest rates, inflation and risk diversification. This test targeted fundamental financial concepts and was designed for the general public. It’s perfect for first-year students or those with limited financial backgrounds.
For students in finance programmes or postgraduate studies, you have the flexibility to customise questions. Consider addressing more complex topics such as expected portfolio returns, risk-return calculations for investments and risk management using derivatives. The key here is to adapt the questions to the class’ targeted proficiency level necessary for a future career.
Step 4: Comparison and discussion
Finally, bring together the results for a lively and enlightening discussion. Some students might realise they overestimated their subjective knowledge when they rated themselves highly at first, yet went on to struggle with the “Big 3” test questions. Others will find themselves in the opposite scenario and realise they are better than they think. This can spark a productive conversation on overconfidence and the importance of objective self-assessment.
My research with Khaled Merhab, “Re-examining the Dunning-Kruger effect: objective vs. subjective financial literacy in the young and overconfident”, demonstrates the efficacy of this four-step process in identifying overconfident students while keeping the learning experience engaging. Providing contextual information about overconfidence is a good practice, fostering awareness among students about potential pitfalls.
The good news is that education emerges as a potent antidote to overconfidence, as students’ progress correlates with diminishing levels of this trait. Age and maturity play a pivotal role, with overconfidence being more pronounced among those under the age of 21. Considering the wealth of evidence and the potential for costly mistakes stemming from overconfidence, it is a good practice to engage students in this exercise and equip them with valuable self-awareness.
Ekaterina Ipatova is a senior lecturer in finance at the University of Roehampton.
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