Overconfidence in Stock Trading

How many times have you felt that you have superior skills in stock trading than anyone else? How many times have you felt that nothing can go wrong? Well, if this is what you feel or felt recently, you are suffering from a condition known as overconfidence syndrome in stock trading. Overconfidence in the stock trading is extremely risky because we mistakenly believe that we have superior skills in predicting market movement with the highest level of accuracy. Make no mistakes no one can predict the stock trading perfectly; not you, not me, and not even the professional portfolio managers.

Humans suffer from a psychological bias called self-attribution. When things go well, we attribute results to our own actions. If things don’t go our way, then we blame bad luck. Additionally, when things do go our way, success further reinforces our belief that we truly have the Midas touch. This kind of human behavior is being called overconfident. Unfortunately, when we are overconfident, we misjudge our values, opinions, beliefs or abilities and we have more confidence than we should given the objective parameters of the situation.

It may be surprising, but overconfidence also occurs in our investment decision making knowingly or unknowingly. Generally the stock market not only functions on the company’s performance but is also influenced by investors’ psychology and biases. One of the major biases in stock trading is overconfidence. But how do we differentiate between confidence and overconfidence? There is a very thin line between confidence and overconfidence. Confidence implies realistically trusting in one's abilities, while overconfidence usually implies an overly optimistic assessment of one's knowledge or control over a situation. Let’s look at a typical situation when we unknowingly become overconfident investors.

Mr. Ram bought 100 shares of company “A” (at Rs. 1000 of per share) one year ago. He bought these shares based on Mr. Shyam suggestion. He was not sure then but since Mr. Shyam has very good knowledge of stock market and also bought some shares of the same company “A”, he decided to follow Mr. Shyam’s suggestion. Fortunately for Mr. Ram, the share price of company “A” increased to Rs. 1200. He sold these shares at Rs. 1200 per share six months ago and made a good profit from trade. Based on the profit he gained, he became more confident to trade in stocks and decided to trade more. We provided below two possible scenarios of trading by Mr. Ram:

Scenario 1

After gaining good profit from company “A” six months ago, Mr. Ram chose company “B”s stock and discussed with some of his colleagues and friends. Initially he was planning to invest Rs. 200,000 in company B’s stock, but when he analyzed the balance sheet of the company, he decided to invest only Rs. 100,000 based on his own assessment of risk and return preferences.

Scenario 2

Just two days ago, he sold company B’s stock and made a profit from the trade. The NEPSE is in the rising trend and looks like everyone is trading to take benefit from the current stock market situation. Mr. Ram decided to invest more money in company” C” this time without discussing with anyone or without looking into the company’s balance sheet and trading history. Based on gains from last two trades, he became very confident and felt that he has some knowledge of market timing and this is the right time to invest in company C.

If we carefully analyze above two scenarios, the first one represents confidence level of Mr. Ram whereas in the second one, he appears to be more confident or overconfident. The second scenario is very risky as he ignored the market situation and company fundamentals before deciding to invest in company C.

Overconfidence has two components: overconfidence in the quality of our information, and overconfidence in our ability to act on said information at the right time for the maximum gain. Overconfident investors’ believe that they know which stock they need to buy, and which ones they need to sell. Most importantly, overconfident individuals overestimate their skills of predicting future stock return and underestimate the degree of risk they take while trading. For example, in the second scenario when the market is rising, it is not a good idea to buy stock, rather it is a time to sell. We can buy a stock during the rising market trend if we can identify a undervalued stock, which is difficult for a general investor like Mr. Ram. Therefore, he unknowingly underestimated the risk of trading in the second scenario by overestimating his skills for selecting the right stock for trading.

Investors with too much confidence in their skills often buy and sell too often, which can have a negative effect on their returns. Research shows that those who buy and sell often are at a disadvantage compared to those who take a long-term view and trade less frequently. A common type of overconfidence stems from inexperience. For instance, more than 70 per cent of naive investors wrongly assume they are enjoying above-average returns. We need to understand that overconfidence is not only a problem with individual investors, but it also with professional portfolio advisors/managers as well. Bear in mind that professional fund managers/portfolio managers who have access to the best investment industry reports and use extensively computer models can still struggle at achieving market-beating returns. The best funds managers know that each investment day presents a new set of challenges and those investment techniques constantly need refining. In a 2006 study entitled “Behaving Badly,” researcher James Montier found that 74 per cent of the 300 professional fund managers surveyed believed that they had delivered above-average job performance. Of the remaining 26 per cent surveyed, the majority viewed themselves as average. Incredibly, almost 100 per cent of the survey group believed that their job performance was average or better. Clearly, only 50 per cent of the people surveyed can be above average, suggesting an irrationally high level of overconfidence these fund managers exhibited. As we can imagine, overconfidence (i.e. overestimating or exaggerating one's ability to successfully perform a particular task) is not a trait that applies only to professional portfolio managers/advisors.

 

How to throw out overconfidence from investing?

We all have individual goals, requirements, desires, fears and hopes for our wealth. We all have different habits, different people we trust for advice, and different beliefs about the right decision on any occasion. But we all exhibit very similar psychological biases in our financial decision making, which can lead to poor portfolio choices and subsequent investment performance. Understanding our financial personality is vitally important. It can help us understand why we make the decisions we make, how we are likely to react to the uncertainty inherent in investing, and how we can temper the irrational elements of investment decisions while still satisfying our individual preferences. Therefore, the next time, before you buy a stock, please consider the following questions:

  • Are you being overconfident in your assumptions to buy a stock?

  • What impact will the decision have if it backfires?

  • Have you made a similar assumption in the past that has turned out to be incorrect?

  • Question yourself, and your judgment.

  • And pay attention to people who are questioning your judgment.

 

A sizable population of overconfident investors is always sure of what they believe to be right. But we need to understand that security in share selection is a difficult task. It is precisely at this type of task that people exhibit their greatest overconfidence. Therefore be careful and think before making any investment decision. There is a saying in investment “A fool who overestimates his ability in a market buys questionable securities without any regard to their quality, with the hope of quickly selling them off to another investor (a greater fool), who might also be hoping to flip them quickly.” Therefore, don’t be a fool or a greater fool in the stock market.