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.