Exploring the Role That Overconfidence Plays in the Degradation of Financial Capability

Abstract

Traditional finance theory suggests that market participants are rational and make decisions that are bound by logic and forethought. In contrast, behavioral finance theory recognizes that people do not always follow a rational pattern when making investment and financial decisions. Financial knowledge and skills shape an individual's financial behavior.  Biases, heuristics, and framing effects can prevent an individual from behaving rationally. A bias is a predisposition toward an error; heuristics are a basically "rule of thumb,” and framing effects influence decisions based a prescribed belief and how the information is presented. These combined result into overconfidence, which is the propensity for individuals to believe they possess superior skills in given situations.  Overconfidence is the primary recurring theme in past behavioral finance studies relating to the degradation of financial capability.