07 April 2023

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Overconfidence and how to prevent it

Luigi Campopiano

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“Every investor's biggest problem and worst enemy is himself,” said Benjamin Graham, an economist who is viewed as the father of value investing. Investors often have too much faith in their own abilities, they consider themselves better than they are and often end up getting burned.

Overconfidence is probably the most common and well-known behavioral bias when it comes to investing. The most common way it has been studied is by asking people how confident they are about their beliefs or the answers they provide.

From a psychological point of view, this bias arises from the asymmetry in the weight that investors give to the information they have. When we have an investment idea, the information that could support our thesis is considered more reliable than the information that goes in the opposite direction. And, if over time our thesis does not come true, even in this case the confidence in our choice tends to remain stable. This distortion is known as confirmation bias, a tendency to ignore data and information that could convince us that we were wrong.

Another type of mental trap is the so-called "hot hand fallacy." This is the mistaken belief that a person who has succeeded in one previous event has a better chance of success in other attempts. As Nobel Laureate Richard Thaler explained, this is the classic mistake people make: thinking that what is happening now will continue to happen in the future.

Over the years, many studies have confirmed the existence of "too much trust" and many of its properties have been clarified. The less you know, the more confident you are. The opposite is also true: the more you know, the less confident you are. 

With more difficult questions, you tend to be more confident; overconfidence is not correlated with age or gender or with the intelligence quotient. We are all subject to it, especially when the problem in question is difficult and personal knowledge is limited: two characteristics present in investment activity.

In terms of concrete consequences, several studies have shown that, in general, investors damage their gross and net performance by trading frequently. They signal excessive confidence in their ability to select stocks, bonds or funds, as opposed to a simple buy and hold, regardless of portfolio size, rising and falling markets or equity styles. Further evidence that most investors, both professional and amateur, tend to have trouble beating market indices consistently.

In conclusion, reviewing your trading data and costs can be a good exercise to reduce overconfidence. 

When conducting the review, it's important to remain objective and ask yourself questions like, "Why did I buy that stock?" or “Why did I sell?” If you can identify the behavioral patterns of your trading activity, it will be easier to correct any mistakes.