Overconfidence in Investing: How Emotions Can Impact Your Returns
Overconfidence is a psychological bias that can plague both amateur and experienced investors. This type of excessive optimism can cause investors to make decisions that are not supported by reality. Overconfidence often results in poor investments and lower portfolio returns.
While some degree of confidence is essential to succeed, overconfidence in investing can lead to numerous mistakes including excessive trading, concentrated portfolios, and a reluctance to reevaluate investments when new evidence suggests changes are needed.
Understanding how overconfidence bias occurs and how to recognize the signs within yourself can help mitigate its effects and make you a more effective investor.
What is Overconfidence Bias?
Overconfidence bias refers to an unrealistic sense of certainty, precision, and superiority, often in the face of conflicting evidence. In investing, it refers to investors having exaggerated perceptions of their skills, knowledge, and abilities.
There are several ways overconfidence can manifest in investing:
• Believing you can pick winning stocks based on little information. Overconfident investors tend to see patterns where none exist and think they have devised an infallible investing strategy. In reality, fundamental and technical analysis only account for a fraction of stock price movements.
• Underestimating risks and overestimating returns. Overconfident investors frequently ignore risk metrics like standard deviation and instead focus solely on potential gains. This can lead to excessive risk-taking and poor asset allocation.
• Refusing to cut losses on bad investments. Overconfident investors often double down on losing investments instead of selling. They convince themselves the stock will rebound or their investment thesis is correct despite evidence to the contrary.
• Excessive trading. Overconfident investors frequently trade more than is necessary due to the unjustified belief they can time the market. The reality is that the majority of retail trades reduce returns due to fees and unfavorable purchase prices.
• Narrow focus. Overconfident investors tend to concentrate their portfolios heavily in one industry or investment style they think they understand well. This lack of diversification increases risk without providing higher returns.
Causes of Overconfidence Among Investors
There are several psychological factors behind overconfidence bias:
• Illusory superiority. People generally view themselves as better or more skilled than average compared to their peers, which can cause overestimation of investing ability.
• Confirmation bias. Investors tend to seek information that confirms their beliefs and ignore evidence that contradicts them. This skewed data gathering leads to overconfidence.
• Hindsight bias. After an event occurs, it seems more predictable in hindsight, leading investors to think they knew more than they actually did.
• Attention bias. Investors tend to pay undue attention to stocks that perform well, reinforcing their perception of stock-picking ability. They ignore underperforming investments.
• Self-attribution bias. Investors take credit for lucky gains, but attribute losses to external forces beyond their control. This worsens overconfidence.
While emotions like overoptimism and greed can foster overconfidence, poor discipline and a lack of diversification are more likely the root cause of lower returns. The desire for outsized gains without regard for probability or risk leads rationality to take a backseat.
How to Overcome Overconfidence in Investing
While a bit of confidence can benefit investing performance, overconfidence has the opposite effect. Some ways to mitigate its impact include:
• Set realistic goals. Instead of seeking returns that defy statistical odds, base targets on historical asset class performance.
• Follow a strategic asset allocation. Rather than picking individual stocks in sectors you favor, diversify your portfolio across multiple asset classes based on your risk tolerance.
• Automate investments. Putting money into automated solutions on a set schedule helps avoid emotion-driven decisions that overconfident investors tend to make.
• Avoid excessive trading. Minimize fees and opportunity costs by restricting yourself to trading only when truly necessary rather than trying to time the market.
• Reevaluate periodically. Check that your investments still align with your objectives, risk tolerance, and time horizon. Overconfident investors can be reluctant to admit errors.
• Acknowledge mistakes. Admit when an investment was a poor choice and learn from the experience. Overconfident investors tend to double down on bad investments.
• Seek outside perspectives. Discuss investment choices and portfolio allocation with an unbiased financial advisor or seasoned investors. Fresh eyes can help combat overconfidence.
• Stay data-driven. Base investment decisions on verifiable evidence rather than unjustified hunches. Overconfident investors can become too enamored with their intuitions.
With an understanding of how overconfidence bias occurs and what triggers it, investors can make choices that consider probabilities, risks, and evidence instead of decisiveness and perception. Taking steps to mitigate overconfidence can help investors make choices that better align with their long-term financial goals.
