What is overconfidence bias?
Overconfidence bias causes people to become too sure of themselves and their trading skills, taking a grandiose view of their abilities. This bias causes traders to take risky market positions, due to their belief that they – not the market – cannot fail.
It can hit any trader anytime. Imagine that you open a position and win, make it higher – win, double the volume – win! Wow, you like to win! You need more. More trades, higher positions…Passions are rising.
Oops, the stock trend turns against you and you fail.
Simple psychology says that people believe in themselves and are often proud of what they do. That is fair enough, but apart from making them cocktail party bores, it can affect their behaviour as a trader; they can become conceited about their skills.
They think they know more than fellow traders in a specific sector and think they are pretty smart. The problem is, having too much confidence can force a trader to make irrational decisions that cause his account to suffer.
Overconfidence in trading leads to ‘overtrading’ that costs a lot more money and results in underperformance. Or may even destroy your capital. A bit of reasonable doubt and discretion will never be amiss.
Start making risky decisions based on your gut feel? It is a slippery slope. Trading for the trade’s sake will not get you far. Knowing when NOT to trade can be even more important than to catch a big trade that will make you a fortune.
Overconfidence bias in trading and investing
Extremely prolific in capital markets and behavioural finance, overconfidence is a very dangerous bias. It turned out that the majority of market analysts believe they are above average in their analytical skills.
According to the survey, conducted by James Montier, 74% out of 300 professional fund managers believe in their superior abilities in investing. Only 26% admitted they were average. And no one actually thought their investing skills were below average.
Overconfidence in investing creates an illusion of control and knowledge. It makes traders prone to making mistakes in their practice. Overconfident traders tend to overestimate their knowledge, underestimate risks and exaggerate their ability to control events.
Causes of overconfidence
Behavioural finance says overconfidence may be caused by several things, such as:
- Self-serving attribution bias. Self-attribution bias is the bias where traders attribute their success to their own actions and abilities, while, on the other hand, they refuse to believe that poor trading results are their own fault. This bias prevents investors from learning from their mistakes or acknowledging the need to be better informed.
- Familiarity bias. It happens when people feel confidence only in the things they know, for example, the markets which seem familiar to them. Familiarity bias is the preference of traders to invest in stocks from their home country, in sectors familiar to them or globally renowned branded shares. The illusion of familiar may also lead to overconfidence.
- Illusory superiority, or the above average effect. It happens when traders overestimate their own abilities and skills. When asked, the majority of people believe they are better than average. In a loose sense, we may say that we tend to be naturally overconfident.
The fear of being wrong may be helpful
In many aspects of our life confidence is considered a strength. In investing, it may become more like a weakness. Successful trading experience cannot do without careful risk management. However, overconfidence in your investing decisions interferes with the ability to develop and successfully apply effective risk management strategy.
In his interview to Forbes, Ray Dalio, founder of Bridgewater & Associates, the world’s largest hedge fund, express his firm believe that overconfidence can lead to disastrous results. Mr. Dalio is convinced that a great deal of his success became possible due to avoiding the overconfidence bias. No matter how confident he was in any single trade, he always worked out the worst-case scenarios to take all appropriate measures to minimise potential loss.
Types of overconfidence
The examples of how overconfidence may play out in real life, is the best way to go through the notion of overconfidence in trading. The list below includes the most common type of the overconfidence bias.
Over ranking
It happens, when someone rates their own performance better than it actually is. People used to think about themselves better than they are. It usually ends up by taking too much risk.
Illusion of control
It emerges, when people are sure they keep control over a situation (a market, trend, etc.). People tend to believe they have more control and power than they really do. It also leads us to believe that the situation is less risky, then it really is.
Timing optimism
Sometimes people cannot estimate time needed to complete some work. Very often they underestimate how long it may take to get things done. It becomes hard to predict how long a project will need to complete. Traders often underestimate how long it will take for an investment to pay off.
Desirability
Sometimes, people want something so badly that they do not pay attention to the odds. This is often called a “wishful thinking”. Traders think that a certain positive outcome is more probable, just because you want so.
How to avoid overconfidence?
We cannot fight our biases per se – most of the time they are automatic and subconscious. The best thing we can do is to face them – to become aware of their presence in our lives and build a defensive strategy against them. Overconfidence bias can be avoided by being realistic about the market and your abilities as a trader. Carefully analyse the market patterns using charts, news and other available materials, and be honest with yourself about your trading skills and ability.
