Sunday, November 29, 2015
Confident about overconfidence - Too much confidence hurts
What is becoming clear from behavior research is that investors are overconfidence in their abilities. Overconfidence comes in two forms - overoptimism and over precision. With overoptimism, we have more confidence in our abilities and our ranking relative to others. We are all above average drivers and investors. This leads to the self-attribution bias. We believe that if we receive high returns it is due to our skill and any mistakes or poor returns are attributed to bad luck. Overprecision states that we have too much confidence in our forecasts. We overestimate our accuracy with any forecast we make.
The result of overconfidence is that we trade more than we should because we believe that we are better than our peers and more accurate in assessing valuation. Overconfidence can help explain the active investing puzzle. There is high volume during periods of uncertainty because investor do not believe in the uncertainty they face. They know better. This can lead to overreaction and momentum in pricing as confidence drives more trading.
If you want to be a better trader, show more humility with ability. This does not mean that you should always be cautious, but realize that your forecasts and skills may not be as good as you think.