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.