Beware of Overconfidence Bias

Beware of Overconfidence Bias

I spend a fair amount of time warning people about emotion-linked investment mistakes.  However, other psychological tendencies such as an overconfidence bias can be detrimental.


Investopedia provides the following about Overconfidence:


Overconfidence has two components: overconfidence in the quality of your information, and your ability to act on said information at the right time for maximum gain. Studies show that overconfident traders trade more frequently and fail to appropriately diversify their portfolio


One study analyzed trades from 10,000 clients at a certain discount brokerage firm. The study wanted to ascertain if frequent trading led to higher returns. After backing out tax loss trades and others to meet liquidity needs, the study found that the purchased stocks underperformed the sold stocks by 5% over one year and 8.6% over two years. In other words, the more active the retail investor, the less money they make. This study was repeated numerous times in multiple markets and the results were always the same. The authors concluded that traders are, "basically paying fees to lose money."


How to Avoid This Bias Trade less and invest more. Understand that by entering into trading activities you're trading against computers, institutional investors and others around the world with better data and more experience than you. The odds are overwhelmingly in their favor. By increasing your time frame, mirroring indexes and taking advantage of dividends, you will likely build wealth over time. Resist the urge to believe that your information and intuition is better than others in the market.


Investors should constantly questions their views on the direction of markets in short-term.  If you believe it’s time to sell because you believe markets will fall remember that even those that dedicate their entire careers to forecasting markets don’t know and if you can’t resist trading based on your directional beliefs it may be better to not invest at all.  


Another aspect that is worth thinking about is the idea that investors should pick an adviser based on their investment skills. Having spent most of my career evaluating investment managers and meeting with investment advisors I can say with certainty if you think you can pick an adviser based on their investment skill you have fallen victim to overconfidence bias.


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