Avoiding Overconfidence Bias in Your Trading Decisions
Is overconfidence leading you to make bad trading decisions? Learn about overconfidence bias and how you can avoid it to make better financial moves.
Is your investment ego costing you?
Confidence isn’t a bad thing, but overconfidence is a one-way road to poor portfolio performance. Overconfidence bias isn’t uncommon, especially in young investors. So, how can you avoid overconfidence bias in your trading decisions?
Overconfidence Bias Explained
First, let’s discuss what overconfidence bias means — it’s when a person overestimates their abilities, skills, and knowledge. This overestimation can lead to poor decision-making and significant errors in judgment.
Overconfidence is a common issue that can lead to someone making bad financial decisions; it can also reinforce other problems, resulting in other types of biases.
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The Problem of Overconfidence Bias in Trading and Investing
If you had to name one trading and investing skill as the most important, what would you choose? We’d go with understanding how the market moves. Many traders and investors overestimate their ability to predict which direction markets will move in, even if it’s statistically impossible for the majority of them to be above average in their predictions.
One substantial danger of overconfidence bias is losing money more quickly — this bias makes it more likely to commit to investment decisions, whether they are correct or not.
Overconfident investors trade more often, resulting in lower returns and more spent on transaction fees. It also causes them to underestimate trading risks, making decisions without assessing the consequences.
Ironically, overconfident traders set themselves up to underperform — more frequent trades mean more possibilities of making costly mistakes. Other risks of overconfidence bias include creating a poorly diversified portfolio and ignoring evidence that contradicts their decisions.
How Traders Can Fall Victim to Overconfidence Bias
There are several ways investors can become overconfident. For example, it’s not uncommon to overestimate your trading abilities and the accuracy of your information during bull markets — everyone feels like a genius trader when the market is up.
Memory distortion (or positivity bias) can also lead to overconfidence when traders remember past losses as less negative and past wins as more positive than they were. There’s also something called selective forgetting, meaning we’re more likely to remember substantial gains and less likely to remember significant losses.
This process runs counter to the theory of loss aversion, which states we feel more pain from a loss than we do joy from an equivalent gain. However, we’re more likely to forget about the losses than the gains over the long term.
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Causes and Signs of Overconfidence Bias
Because overconfidence bias affects someone’s ability to make judgments, it’s defined as a cognitive condition. Several cognitive factors contribute to the overconfidence bias, including:
- Heuristics (a cognitive framework that simplifies and speeds up decision-making)
- Biases that cause people to deviate from objectivity
- False beliefs based on selective recall
Overconfident traders believe they can beat the market, often partake in excessive trading, and frequently change their investing strategies. Another sign of overconfidence bias is when someone downplays or disregards the risks associated with specific types of investments.
They also tend to ignore feedback and advice, believing that their own judgments are the only correct ones.
Types of Overconfidence Bias to Avoid
Let’s explore the common types of overconfidence bias and what they look like.
Illusion of Control
This overconfidence bias is when someone falsely believes they have control over something. For example, in investing, an overconfident trader might believe they can influence or predict market movements.
However, timing the market or predicting its movements is often influenced by factors beyond the investor’s control.
Closely related to this bias is the illusion of knowledge, or believing that you have more info about something than you actually do. But more information doesn’t mean it’s better information than someone else has and doesn’t necessarily lead to making better financial decisions.
When someone underestimates the likelihood of poor outcomes and overestimates the probability of positive outcomes, it’s called optimism bias. In trading and investing, this bias can result in underestimating risks or overestimating the ability to make better financial decisions than others.
Finally, miscalibration is the tendency to have irrational levels of confidence in market predictions, resulting in a disconnect between an investor’s perceived and realistic abilities.
Related to miscalibration is overprecision, meaning someone thinks they will know the exact movements a stock will make based on things like earning announcements.
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How to Overcome Confidence Bias in Your Trading Decisions
There is a solid three-step program you can follow to help overcome overconfidence bias.
Go Back to the Fundamentals
Are your personal valuations of stock different from the market? Well, you better have some well-founded reasons for those valuations.
Look back to the fundamentals — there’s a reason why analyst reports back up price and fair value estimates. Professional analysts base stock ratings on company financials and fundamentals backed up by pages and pages of data.
How likely is it that your valuations are more accurate?
Look at Your Past Investments
If you feel like you can 100% beat the market in the future, take a minute to look back at the past. What was your return on investment over the past few years? Compare those numbers to the returns of the Dow or S&P 500; did you consistently beat the market? Probably not.
Review Your Past Statements
Overconfidence bias is challenging to overcome if you’ve had great successes in the past; it can make you feel confident in your skills and believe you have better insights than others.
However, you should first look at your past few months or years of statements and answer the following questions:
- What trades were the most profitable, and how much did you gain?
- What trades brought the most losses, and how much did you lose?
- Would your returns have been better if you didn’t make any trades?
- What was the return for relevant benchmark funds or ETFs?
By performing these simple checks, you can avoid overconfidence bias — they help base your valuations on facts and correct causes of overconfidence, like memory distortion and selective forgetting.
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