Overconfidence Bias
Scholars believe that, in general, confidence is a positive trait. It can make a person more resilient, personable, and optimistic. However, too much confidence can also cause individuals to overestimate their abilities, leading to faulty decision making. In the case of investors, overconfidence can invoke a lack of sound judgment, cause an individual to make irrational investment decisions, and prompt a defiant disregard for expert advice. Overconfidence signals to the brain that “you know what is best” and “your knowledge surpasses others.” Thus, this state of mind gives people an illusion of superiority and control, causing risky behaviors regarding money and investing strategies.
Overconfidence can manifest itself several ways through investing:
Overtrading
Overtrading is when a person excessively buys and sells stock, often to recoup their capital after a string of losses. These individuals have a “push the envelope” mentality and are overconfident in predicting short-term market direction. Market timing, however, is extremely difficult to execute correctly. As a result, they statistically end up underperforming, paying more commission fees, and facing higher taxes. In fact, according to a study by THE JOURNAL OF FINANCE VOL. LV, NO. 2, there is a correlation between higher trading levels and lower performance results of individual investors. However, what is considered too frequent trading? That all depends on the individual’s personal goals and plan with their financial advisor.
Less Diversification
A common consequence of overconfidence is an overly concentrated portfolio. By overestimating their own expertise, overconfident investors often “put all their eggs in one basket” and build portfolios that are too concentrated amongst too few investments. This certainty regarding a particular stock or sector can hurt long-term portfolio performance if an investor misplaces their confidence in a poorly performing investment. We can see the dangers most clearly through example. If an individual’s portfolio contains only tech stocks and tech stocks plummet relative to other sectors, this individual would suffer substantial losses compared to an individual with a well-diversified portfolio. Sufficiently diversified portfolios may help mitigate market risk and provide a foundation for long-term growth.
At one time or another, everyone falls into behavioral biases. That is why it’s essential to identify and overcome these biases to make sound investment decisions. A common saying is “the greater the risk, the greater the reward.” However, like the ever-shifting market, finance is a unique industry involving balance, patience, and planning. Too much confidence and risk can be dangerous. In contrast, too much hesitation and safeguarding can hinder financial progress. At Moran Wealth Management® , we utilize a disciplined and quantitative approach aimed at allowing us to sidestep the common investing pitfalls. If you are interested in learning more about our investment philosophy and speaking to a financial advisor, please contact us at (239) 920-4440.
This blog article contains general information that is not suitable for everyone and was prepared for informational purposes only. Nothing contained herein should be construed as investment advice. Moran Wealth Management®, LLC (“MWM”) is a Registered Investment Adviser. The information contained herein is based upon certain assumptions, theories, and principles that do not completely or accurately reflect any one client’s situation or a while exposition of the topic. All opinions or views reflect the judgment of the author(s) as well as of the publication date and are subject to change without notice. For additional information about MWM, including its services and fees, request the firm’s disclosure brochure using the contact information herein or visit advisorinfo.sec.gov.
Citation: Barber, Brad M, and Terrance Odean. Trading Is Hazardous to Your Wealth: The Common Stock Investment Performance of Individual Investors. https://faculty.haas.berkeley.edu/odean/Papers%20current%20versions/Individual_Investor_Performance_Final.pdf.