Overconfidence and status quo bias are real dangers when trading. As are our characters: everyone is their own worst enemy. An axiom so worn out it almost passes for verbal white noise.
But overcoming our characters is important. Overconfidence in decision making has the potential to wreck our finances (and, yes, relationships). Status quo bias can be equally destructive, if we’re not careful. Both contain multiple traps that can clamp trading returns.
Behavioural finance studies warn of the over-confident trader. In trading this is the gap between the certainty of our decision-making (and self-serving reasoning, often) and its real-world result. The gulf can prove extreme, even for experienced traders.
- A key feature of over-confident bias is that when it disproves a trader’s judgement – hard news, public information from trusted sources – it doesn’t contract in proportion to the result
- Practically this bias also has a real-world cost
- Not just with on-going lower performance results but time, energy and cash: money wasted in trading charges and other fees
An over-confidence bias often also leads to even more trading. (Overtrading has been shown to kill trading and investment returns over the long term.)
True believers are dangerous
No-one knows where the market will go tomorrow. One key ingredient to successful investing and trading is (‘exuse the new-age argot) ‘letting go’. For over-confident traders this idea goes to the root of the illusion of control.
But you can look for trades and investments that will broadly fit your goals. In other words, trades that offset risk while supplying a measure of hoped-for profit exposure.
Scientific studies tend to place overconfidence in three areas:
- Overestimation – when we are sure we can complete a task or job within a certain time period but fail to do so
- Overprecision – the tendency to believe that our reasoning is correct or accurate, particularly on predictions about the future
- Overplacement – that our judgement is more accurate that others’
Think of other rational decision-making we make regularly: what food to buy or eat, when to pay a utility bill, how often to pay a tax bill. If you make well-planned decisions on these, why should trading be different?
Status Quo Bias
In short, this bias is about our in-built inertia. We’ve all got it. It’s a human response for lazy decision-making that allows us to manage daily routines quickly.
It’s also a survival response to be efficient. But if embedded deeply enough, status quo bias is particularly damaging for traders because markets are rapidly-moving animals.
At the heart of status quo bias is a reluctance to believe that alternative options are superior to the status quo. For too many situations this in-built bias suggests any change will be a loss.
Take power back
Modern life is good at encouraging a status quo bias because of the exhausting super-abundance of choice, from investments to pet food to holidays and property.
Status quo bias however can be re-framed, be it in marketing products or political campaigns. Think of the UK Brexit referendum. Much of the argument against the ‘status quo’ was the idea of ‘taking back control’.
Chief executive of advertising player M&C Saatchi, Moray MacLennan, told Campaign magazine he wanted the anti-Brexit Remain camp to run with a positive message.
"We said don’t try to cower people into submission – encourage them to see the positives. We came up with a strategy based around ‘Don’t leave it, lead it’ but they didn’t run with it."
So much depends on how the status quo is positioned, as well as how much emotional freight it carries.
Status quo bias can be managed by:
- Setting regular dates to review and change our trading tactics or portfolio
- Asking questions about our decisions: is the default choice really the safest? Why do I value it so much?
- Seeking out alternatives that offer compelling ideas that may well be more profitable, short and long term (though this re-framing can be difficult because it is new and unfamiliar)
Status quo bias though has reproductive tendencies. Its offshoots include Omission Bias, Conservatism Bias and Herd Instinct Bias. It can lead to ignoring fundamental analysis basics – think dividends and earnings ratios – and other tricky evaluations.
That trickiness, bear in mind, is why status quo bias is so attractive – because overcoming it requires work. The default choice is therefore inaction.
The irony is that our brains get a much-needed workout or refresh when offered an alternative. Our neural circuits start to glow and pop. Energy arrives. Change happens…and the status quo is overturned.