What is Overconfidence?

In this article, we take a look at what is overconfidence bias and how it affects your investing decisions.

Overconfidence is the tendency to overestimate our abilities and intellect. It affects the way we interpret information and make decisions. In other words, it makes us believe we’re better than we are.

A classic example of overconfidence bias is the fact that most of us believe we have far above-average social skills. We’re also quite fascinated with our driving skills since the majority of us believe we are better at operating our vehicles than the rest.

In investing, a confident investor believes he can pick a great company – an overconfident investor knows it.

How Overconfidence Bias Affects Your Investing

Picking stocks without proper research is a game of chance. Even with extensive fundamental analysis, there are endless possible factors affecting the price of a stock that cannot be foreseen or calculated.

The overestimation of our abilities makes us think we can somehow control events that are beyond our control.

Overconfidence bias makes investors think it is somehow possible to achieve the unachievable and forecast the future.

This is because it’s easier to explain the past than predict the future. Overconfidence bias tricks the mind to believe that the future is also explainable and therefore predictable. If you find yourself believing you know what will happen in the next five years, it is wise to do a reality check.

When you think you can beat the market by predicting future stock prices, you will most likely lose a lot of money.

Especially after a long bull market, it is typical for investors to believe that it’s easier to beat the market than it is. Even riskier investments seem to always pay off because everything is going up, which builds confidence in investors’ skills.

The more confident people get, the more they invest. When the stock market eventually takes a turn for the worse, potential losses can be quite devastating. In other words, the risk level for an overconfident investor rises tremendously.

What’s worse, overconfidence bias makes people believe they can handle more risk than they actually can. This is because an overconfident investor thinks that even his most risky investments will pay off.

When you think about it, the risk is considerably easier to bear when the chance of failure is removed from the equation.

Unfortunately, the risk is still there whether the investor realizes it or not. Overconfidence leads investors to assume more risk than they are aware of.

If you’re not sure what’s your appropriate risk level, you might want to take a look at how to define your risk profile.

Overconfidence is especially dangerous when coupled with confirmation bias, the tendency to collect and interpret information to support the investor’s original view. This means the investor is not only wrong about his original view but also seeks and interprets information so that it confirms the original, flawed analysis.

Another common symptom of overconfidence is excessive trading. On average, unfortunately, more trades mean lower returns, which means it is usually more profitable to do nothing.

More importantly, people tend to sell the winners and hold the losers. What’s even better is that investors usually underestimate the number of trades they make and overestimate the success of those trades.

As we can see, an overconfident investor is far from rational. The worst part is that overconfidence leads a person to think the exact opposite.

In essence, overconfidence makes investors believe they’re possessing traits they necessarily aren’t, which leads to poor investment decisions.

How to Avoid Overconfidence

So far, we have established that it’s best not to have too much confidence. The problem is that when we’re being overconfident, we rarely realize it ourselves. So, how can we make sure we stay humble?

The first thing is to try and be objective about your investment decisions and portfolio performance. It’s better, to be honest with yourself and look at the numbers, even though it might be quite painful at times.

It is helpful to keep track of your success by tracking your trades. We tend to forget or downplay our mistakes. Look back and analyze what went wrong and why. It is amazing how often we tend to make decisions, that in hindsight seem completely irrational.

Because overconfidence bias affects the way we make decisions, it is wise to always second guess yourself when making a new investment. Find opinions that contradict your own and try to evaluate them objectively.

It’s also useful to do a reality check now and then. Even if you feel like Midas himself, never invest more than you can afford to lose. There is always a myriad of things we don’t even know we don’t know.

Even if you are dead sure about a company, there can always be something completely unforeseeable, like a war or a global pandemic, that changes everything.

Because of the unknown, you shouldn’t use too much leverage – even if it feels like you’re missing out on returns. It’s usually at the top of the bull market when investors are most confident and use the highest leverage. Unfortunately, the more expensive the stocks are, the lower returns can be expected.

One of the main things to keep overconfidence at bay is to keep learning and constantly increase your knowledge. More often than not, learning will keep you from getting too confident. To learn something new, we must accept and admit we don’t know everything. Sometimes this requires tremendous amounts of humility.

Probably the most important thing is to remain honest with yourself. Investing is a thing you do for yourself by yourself. If you make a mistake (or ten), it’s ok. Sometimes we tend to hide our insecurities by being overly confident, which prevents us from learning from our mistakes.

There’s not a single investor in the world who hasn’t made a mistake. The trick is not to hide and forget your blunders, but to learn from them and gradually become a better investor.

Summary

So, overconfidence is a cognitive bias that makes us overestimate our abilities and knowledge.

Having too much confidence affects your performance and causes problems in your ability to control your actions. Having a false belief in your abilities you’re in danger of taking more risks than you normally would.

I want to clarify that there’s nothing wrong with having healthy confidence and a feeling of certainty when you make an informed investment decision. After all, you have to have some amount of certainty to invest in the first place.

More often than not it’s better to underestimate your investing ability than to have too much confidence. Having too little belief in yourself may cause you to miss out on potential returns, but overconfidence can put you out of business.

The best way to stay humble is to keep learning, being honest with yourself and look for opinions that contradict your own.