One of our favorite and most trusted resources for educational information on investing is www.Investopedia.com. They have earned their keep as a reliable portal for numerous subtopics in the field of investing. As we continue our series on “Behavioral Biases”, we sought the expertise of their academic staff to discuss “Overconfidence Bias”.
Before we highlight their comments, we felt it helpful to provide an overview of how overconfident people are in something as simple and common as driving a vehicle. According to Business Insider; “Despite the fact that more than 90% of crashes involve human error, three-quarters (73 percent) of US drivers consider themselves better-than-average drivers. Men, in particular, are confident in their driving skills with 8 in 10 considering their driving skills better than average.” What is most glaring is that this overconfidence does not diminish with age.
Unfortunately, investors suffer from the same plight when it comes to investing. The fine folks at Investopedia define this peril as; “Overconfidence has two components: overconfidence in the quality of your information, and your ability to act on said information at the right time for maximum gain. Studies show that overconfident traders trade more frequently and fail to appropriately diversify their portfolios.
One study analyzed trades from 10,000 clients at a large discount brokerage firm. The study sought to ascertain if frequent trading led to higher returns. After backing out tax-loss trades and others to meet liquidity needs, the study found that the purchased stocks underperformed the sold stocks by 5% over one year and 8.6% over two years. In other words, the more active the retail investor, the less money they make.
This study was replicated several times in multiple markets and the results were always the same. The authors concluded that traders are, “basically paying fees to lose money.””
Investopedia recommends the best manner in which to avoid the trap of this bias is; “Trade less and invest more. Understand that by entering into trading activities you’re trading against computers, institutional investors, and others around the world with better data and more experience than you. The odds are overwhelmingly in their favor. By increasing your time frame and taking advantage of dividends, you will likely build wealth over time. Resist the urge to believe that your information and intuition are better than others in the market.”
We found this advice to be super helpful and for the complete read on this subject matter check out their website at:
https://www.investopedia.com/articles/investing/050813/4-behavioral-biases-and-how-avoid-them.asp
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