Those shares you bought have risen nicely in price. You definitely made the right decision there. You knew you’d be good at this investment lark.
But before you get to the point of thinking you are invincible, or perhaps even knowing that you are, it is worth considering whether you are making the mistake of believing your own publicity and letting overconfidence cloud your judgement.
The overconfidence effect
Overconfidence is one of a number of behavioural biases that can negatively affect trading returns.
While confidence is helpful to the investor – after all without it you likely wouldn’t trade at all – overconfidence is more likely to be a hindrance.
Thinking that you are good at investing because, well, you are you, will not keep your investment bubble from popping.
Unlikely as the overconfident investor would be to admit it, that bubble may well have been formed by luck rather than superior investment abilities.
Misuse of information
Overconfidence has two aspects:
- Thinking your information is better than everyone else’s
- Not using that information to get the maximum gain from your investments
Overconfident investors tend to overtrade. It may seem logical to think that the more you trade, the better you will do, but studies, such as that by Barber and Odean have shown this not to be case.
Other downsides of being too confident include taking on positions that are too large and overestimating the potential profit from a trade.
Overconfident investors also tend to stick to what they know best, so they have narrow portfolios that leave them more vulnerable to volatility in the markets. A broader portfolio spreads risk.
Another thing to watch out for is self-attribution bias. This is when you take the glory for your good decisions but decide that when things go wrong it was caused by factors outside your control.
Hoffmann and Post analysed the trading records from a Dutch broker alongside customer surveys and found that: “the higher previous period’s returns are, the more investors agree with a statement claiming that their recent performance accurately reflects their investment skills”.
Concentrating on good outcomes can exacerbate the overconfidence effect as any bad trades are reasoned away. It also means people miss the chance to learn from their mistakes.
Illusion of control effect
Rather than ignoring the bad bits, the illusion of control effect lets you think that you can control random events. A classic example is to believe that the numbers you pick in a lottery have a better chance of winning than a lucky dip. Actually each number, and combination of numbers, has an equal chance of success.
Thinking that you influence the outcome of events can lead to overestimating your own ability and being too confident.
It can mean being too optimistic as you believe you can have an effect on the outcome of a risky trade. It can also lead to overtrading or taking too large a position.
Overconfidence crops up in day trading too. Academics Wei-Yu Kuo and Tse-Chun Lin looked at the confidence levels of day traders on the Taiwan futures market.
They found that: “individual day traders are both overconfident in the precision of information and biased in interpretation of their information”.
Everyone is biased. The skill is in recognising what biases you have and how they may impact your trading behaviour.
Keeping a record of your trades and the reasons why you made them is a useful way of seeing if there are any patterns in your behaviour.
It is easy to remember the stocks that did very well or very badly. Others may slip under the radar, so write them all down and study them regularly to spot any patterns.
Set rules when you trade, such as exiting a position when a stock falls by a certain percentage. Don’t hang on for pride’s sake.
Seek out the opinions of people whose views differ from yours. This can help add a different perspective to things.
Focus on what you could be doing better not on how good you think you are.
And recognise that just because you know a lot about a subject does not mean you can influence the outcome. If this were the case, all football fans would support teams that never lost.