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”Underconfident”: How People Feel When Making Decisions About Money

People tend to be slightly overconfident when doing easy tasks when no money is involved. But this overconfidence vanishes when the task is unfamiliar and, even more so, when real money is at stake. Indeed, rather than being overconfident, people are actually ”underconfident” about financial matters: they typically think that the rest of the population is better then they are at the task. These are the central findings of new research by Erik Hoelzl and Aldo Rustichini, published in the Economic Journal.

Are people overconfident? Do they have an opinion about their skill and judgment that is better than they should realistically have? In a classical experiment, people were asked whether they considered themselves better drivers than the average population. A fraction much larger than half answered yes, so that a large number of them had to be wrong. Applying this finding to the opinion that people have of their ability as investors in financial markets seems to predict disaster. For example, if US social security is privatised, a large population of gullible and overconfident investors could be on their way to losing their savings in reckless investments.

Hoelzl and Rustichini”s research tests whether people really are overconfident. They asked people to choose whether they are paid according to a fifty-fifty lottery or according to whether they come out in the better half in a competition. The test is precise and people have the incentive to be correct in their evaluation.

The researchers then use this test to measure how confidence depends on financial incentives and the familiarity of the context. In their experiment, approximately two thirds of people choose the competition when the task is easy and no money is at stake. This proportion falls to one third when the task is hard and money is at stake.

When applied to the issue of financial investments, this result suggests that the initial approach of people after a social security reform might not be one of reckless investment. Indeed, since the task of financial investment is considered hard and a great deal of money is at stake, the real outcome may be one of excessive prudence.

”Overconfident: Do you put your money on it?” by Erik Hoelzl and Aldo Rustichini is published in the March 2005 Economic Journal. Erik Hoelzl is at the Department of Economic Psychology, Educational Psychology and Evaluation at the University of Vienna; Aldo Rustichini is Professor of Economics at the University of Minnesota.

Erik Hoelzl

+43-1-4277-47888 | erik.hoelzl@univie.ac.at

Aldo Rustichini

+1-612-625-4816 | arust@econ.umn.edu