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Overconfidence in Stock Trading

People are overconfident. Psychologists have determined that overconfidence causes people to overestimate their knowledge, underestimate risks, and exaggerate their ability to control events. Does overconfidence occur in investment decision making? Public stock or security selection is a difficult task. It is precisely this type of task at which people exhibit the greatest overconfidence.

Are you overconfident?

Most people are overconfident about their abilities. Consider the following question:

How good a driver are you?

Compared to the drivers you encounter on the road, are you above average, average, or below average? How would you answer this question?

If overconfidence were not involved, approximately one-third of those reading this would answer above average, one-third would answer average, and one-third would answer below average. However, people are overconfident in their abilities. Most people feel that they are above average. When groups of students, professors, professionals, and investment club members were asked this question, nearly everyone answered that they are above average. Clearly, many of them are mistaken and are overconfident about their skill in driving.

Being overconfident in driving may not be a problem that affects your life. However, people are overconfident about their skill in many things. Sometimes overconfidence can affect your financial future. Consider this financially oriented example:

Starting a business is a very risky venture; in fact, most new businesses fail. When 3,000 new business owners were asked about their chance of success, they thought they had a 70% chance of success. But only 39% of these new owners thought that a business like theirs would be as likely to succeed.

Why do new business owners think they have nearly twice the chance of success as others in the same business? They are overconfident.

Becoming Overconfident

We begin the process when we enter a new activity, say, stock market investing. We do not know our ability at investing, so we observe the consequences of our investment decisions. If we are successful, it is human nature to attribute that success to our ability. But not all success comes from high ability. Indeed, some successes come from dumb luck.

Consider the Dartboard column frequently run by the  Wall Street Journal. Periodically, the Wall Street Journal invites four or five stock market investment analysts to pick a stock for purchase. Simultaneously, they pick four or five other stocks by throwing darts at the financial pages. They follow the analysts’ stocks and the dartboard stocks and report the returns produced by both sets. More likely than not, the dart-board portfolio beats the pros.

Does the dart thrower have superior stock-picking ability? No, it’s just that dumb luck success is common. People investing during the late 1990’s probably experienced great returns – it is easy to earn high returns during a strong, extended bull market. Many new investors began investing during this period. The problem arises when the newer investors attribute their success to their ability.

Thus the old Wall Street adage warning “Don’t confuse brains with a bull market!”

Confidence – A Recipe for Disaster?

The attributes psychologists believe contribute to overconfidence are certainly common in our modern investment environment. Indeed, the ingredients for overconfidence by investors may be at their highest levels ever! This overconfidence leads investors to have too much faith in their estimates of stock value and in predictions about the future movement of stock prices.

Read part-2 of Qwoter’s stock market advice on Overconfidence in Investing.

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