Over-confidence bias: the downfall of many traders
Too much self-belief when trading can be a dangerous thing, causing you to make irrational decisions and take risky market positions
Alongside cage diving and stand-up comedy, trading is one of the most challenging, scary and exciting ways to make money.
It requires nerves of steel, self belief and a healthy dose of confidence. When you’re feeling confident, you are more likely to take risks and look for new opportunities. However, note the words "healthy dose".
Too much confidence when trading can be a dangerous thing. Ok, so it won’t lose you a limb or get you heckled off stage, but being cocky can cause you to make irrational decisions and take risky market positions.
According to Ekaterina Serikova, Currency.com’s trade behaviour analyst, over-confidence bias is prolific in behavioural finance and capital markets.
“Simple psychology says that people believe in themselves and are often proud of what they do,” she says. “That’s fair enough but, apart from making them cocktail party bores, it can affect their behaviour as a trader; they can become conceited about their skills.
“They think they know more than fellow traders in a specific sector and think they’re pretty smart. Overconfidence bias needs to be kept under control because the markets make a fool of us all at some point.”
This is backed up by a survey of 300 professional fund managers by James Montier, who has written several books on finance, including Behavioural Investing: A Practitioner’s Guide to Applying Behavioural Finance, and The Little Book of Behavioural Investing. He found that 74 per cent were guilty of over-ranking – that is they believed that they were above average at investing (more on this below).
Overconfidence bias behaviours
Over-confident traders are more inclined to open too many trading positions, take positions that are too large and believe they are better than everyone else – all of which makes for unsuccessful trading outcomes.
Here are some of the most common symptoms of the overconfidence effect.
One of the common signs of over-confidence is over-trading – whether this is trading too frequently, making large trades or taking uncalculated risks.
A great example of this is a study by behavioural finance experts, Brad Barber and Terry Odean, who found a direct link between over-trading and over-confidence bias.
They analysed the trading accounts of around 66,500 households at a large US discount broker between 1991 and 1996. The average household managed an annual return of 16.4 per cent and turned over 75 per cent of its portfolio. However, those that traded the most only managed an annual return of 11.4 per cent, with an average annual turnover of more than 250 per cent.
Most people think of themselves as better than average but for traders this can cause problems as it typically leads to taking on too much risk.
Illusion of control
This bias occurs when traders have the illusion that they have control over the markets. This can be dangerous when investing, as we can think situations are less risky than they actually are. If you fail to accurately assess risk, you will fail to adequately manage risk.
Timing optimism is where people underestimate how long a task or project will take them to get done. One example of this is when investors underestimate how long it will take for an investment to pay off.
Lack of testing
A trader who is over-confident about their plan and their abilities is less likely to test it out. However, testing when trading is vital. You need to test and retest your techniques and systems in order to ensure you can create consistent profits.
Sometimes referred to as "wishful thinking", the desirability effect is when we make the mistake of believing an outcome is more probable just because it’s the outcome we want.
Using outdated techniques
Over-confidence can make a trader closed-minded and this is not a field where you can afford to have your ego prevent you from looking for new techniques and tools, or build new skills.
How to avoid overconfidence bias
Your ego may not want to hear this, but you are not perfect. No trader is. This is why you need to create a plan that incorporates strict money management rules. The more you focus on money management, the less likely you are to rely on your over-confidence bias when trading.
Ray Dalio, founder of the world’s largest hedge fund Bridgewater & Associates, is a great example of how to keep your confidence in check. This is a man who would be justified in thinking he is above average at investing. However, he told Forbes he attributed a significant amount of his success to avoiding over-confidence bias.
“I knew that no matter how confident I was in making any single bet, that I could still be wrong,” he says.
With this in mind, Dalio plans for worse-case scenarios and takes appropriate steps to minimise his risk of loss.
“Overconfidence bias can be avoided by being realistic about the market and your abilities as a trader,” says Serikova. ”Carefully analyse the market patterns using charts, news and other available materials, and be honest with yourself about your trading skills and ability.”
Here's how to overcome overconfidence bias:
- Be realistic about the market.
- Be honest with yourself about your trading skills and ability.
- Carefully analyse market patterns using charts, news and other available material.
- Listen to alternative points of view.
- Keep a record of your predictions and how you came to them and measure them against results.
FURTHER READING: Trading psychology: getting in the mindset of a successful trader