What it means
Psychologists have found that most people think they are better than average at many things, such as driving or judging character. In money matters, this means investors tend to give themselves credit for gains and blame outside events for losses.
The pattern helps people feel good about themselves, but it distorts their view of reality. The bias is a part of behavioural finance, the study of how psychology affects financial choices.
It is closely linked to overconfidence, where people believe their forecasts are more accurate than they truly are. Self-enhancement adds the habit of explaining results in a way that protects self-esteem.
It leads to recognisable mistakes. Investors trade too often, believing they can pick winners, and the extra trading costs reduce returns.
They may hold a concentrated portfolio in a few favourite shares, or stay with losing positions because admitting the error feels painful. In businesses, the same bias appears in budgets, deal making and project planning.
Managers may forecast sales too optimistically and underestimate costs on their own projects. Leaders who attribute success to personal brilliance can overlook the role of favourable market conditions.
Practical defences exist. Keeping a written record of decisions and the reasons for them lets you compare results with your original thinking.
Asking for outside views, using checklists and setting rules in advance all help reduce the pull of an overly flattering self-image. Culture and incentives can make the bias worse or better.
Firms that reward bold calls and punish admitted errors encourage people to hide mistakes, while firms that review decisions openly tend to learn faster. Leaders set the tone by showing that it is acceptable to say a call was wrong.
In practice
Real-world examples.
Example
A retail investor makes three successful share purchases in a rising market and concludes that she has special skill. She increases her trading and puts more money into a few favourite shares. When the market turns, her losses are larger than a diversified investor's, and she is surprised because she believed she could see the turn coming.
Example
A start-up founder projects that his new product will win 25% of the market within two years. He bases the figure on his belief that his team is better than rivals. An independent adviser compares similar launches and suggests that 5% is more realistic.
Example
A fund manager reports strong returns for three years and credits his stock picking. A review shows that most of the gain came from the sector he happened to be invested in, which did well. The firm builds a process to measure skill separately from market luck, comparing each manager's results with those of a suitable benchmark index.
Case study
Seen in the real world.
Quayside Trading Club is a fictional group of friends who pool money to invest. After a strong first year, members credited their own research for the 18% return and increased the amount they traded each month.
Over the next two years their returns fell behind a simple index fund. This is an illustrative story, but the pattern is common. The club's treasurer, Hugo, reviewed the trading records and found that fees and poor timing had cost more than the gains, and the club agreed to keep a decision journal and move most of its money into low-cost funds.
The members still researched a few companies, but only with a small share of the pot. They reviewed results every quarter against the index, which kept the group honest about what was skill and what was luck.
Watch out
Common mistakes.
- Believing only other people suffer from the bias. Almost everyone shows self-enhancement to some degree, including professionals with years of experience, and the belief that you are immune is itself a sign of the bias.
- Judging decisions only by outcomes. A good result can come from luck, and a bad result can follow a sound decision.
- Taking credit for market gains. In a rising market, many investors earn positive returns regardless of skill, so results should be compared with a simple index before drawing any conclusions about ability.
Questions
People also ask.
What is self-enhancement in finance?
It is the tendency to view our own abilities and results more favourably than they deserve, which can lead to overconfidence and excessive risk. It is one of the most widely studied biases in behavioural finance.
How does it differ from overconfidence?
Overconfidence is excess belief in the accuracy of your judgement, while self-enhancement is the broader urge to protect a positive self-image, including by explaining away losses.
How can I reduce it?
Keep a decision journal, compare results with a benchmark, seek outside opinions and set rules before investing. Reviewing past decisions with a trusted colleague or adviser also helps you see them more fairly.
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