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Overconfidence Trading Illusions

If you havent already, it might help to first read the background on Overconfidence in Trading.

Psychologists have found that people become overconfident when they experience early success in a new activity. Also, having more information available and a higher degree of control leads to higher overconfidence. These factors are referred to as the illusion of knowledge and the illusion of control.

Illusion of Knowledge

People have the tendency to believe that the accuracy of their forecasts increases with more information. This is the illusion of knowledge that more information increases your knowledge about something and improves your decisions. However, this is not always the case – increased levels of information do not necessarily lead to greater knowledge.

There are three reasons for this:

  1. Some information does not help us make predictions and can even mislead us.
  2. Many people may not have the training, experience, or skills to interpret the information.
  3. People tend to interpret new information as confirmation of their prior beliefs.

To illustrate the first point, try rolling a fair six-sided die. What number do you think will come up and how sure are you that you are right? Clearly, you can pick any number between 1 and 6 and have a one-sixth chance of being right. What if you were told that the last three rolls of the die have each produced the number 4? If I roll the die again, what number do you think will come up, and what chance do you have of being right? If the die is truly fair, then you could still pick any number between 1 and 6 and have a one-sixth chance of being correct, regardless of what previous rolls have produced.

The added information will not increase your ability to forecast the roll of the die. However, many people will believe that the number 4 has a greater (than one-sixth) chance to be rolled again. Others will believe that the number 4 has a lower chance to be rolled again. Both groups of people will think that their chance of being right is higher than reality. That is, the new information makes people more confident in their predictions, even though their chances for being correct do not change.

Have you switched your money into one of last year’s best mutual funds? Investors have access to vast quantities of information. This information includes historical data like past prices, returns, and corporate operational performance, as well as current information like real-time news, prices, and volume.

Individual investors have access to information on the Internet that is nearly as good as the information available to professional investors. Because most individual investors lack the training and experience of professional investors they are less equipped to know how to interpret stock market information. They may think they have access to all this incredible inside information and that may well be true, but, without the proper training, they cannot begin to guess how that information might shape the future – any more than they can guess future rolls of the die from what was rolled in the past.

The last reason information does not lead to knowledge:

People have a tendency to interpret new information as a confirmation of their prior beliefs. Instead of being objective, people look for the information that confirms their earlier decisions. Consider what happens after a company reports lower earnings than expected – the price usually falls quickly, followed by high volume. High volume means that many people decided to sell and others decided to buy. One news report caused two different behaviors.

Illusion of Control

People become even more overconfident when they feel like they have control of the outcome – even when this is clearly not the case. For example – and this has been documented – if you ask people to bet on whether a coin toss will end in heads or tails, most will bet larger amounts if you ask for the bet before the coin has been tossed. If the coin has already been tossed and the outcome concealed, people will offer lower amounts when asked for bets. People act as if their involvement will somehow affect the outcome of the toss. In this case, the idea of control over the outcome is clearly an illusion.

The key attributes that foster the illusion of control are choice, outcome sequence, task familiarity, information, and active involvement. Investors may routinely experience these attributes.

• Choice

The choice attribute refers to the mistaken feeling that an active choice induces control. Consider your local lottery game. People who choose their own lottery numbers feel they have a better chance of winning than people that have numbers randomly given to them. In the past, most investors used full-service brokers who advised them and helped them make investment choices. However, the rise of the no-advice discount broker shifted the decision making more to the investor. Modern investors must make their own choices as to what (and when) to buy and sell. The more active the investor is in the decision making, the higher the illusion of control.

• Outcome Sequence

The way in which an outcome occurs affects the illusion of control. Positive outcomes that occur early give the person a greater illusion of control than early negative outcomes. Even something as simple and transparent as being right on the first two tosses of a coin can lead to an increased feeling of having the ability to predict the next toss.

• Task Familiarity

The more familiar people are with a task, the more they feel in control of the task. Investing has become a very familiar thing in our society. Consider these indicators:

  • In 2000, CNBC (a financial news TV channel) surpassed CNN as the most watched cable news network.
  • There are more mutual funds investing in stocks today than there are publicly traded companies to invest in.
  • Terms like 401(k) and day trader are household terms.

• Information

The greater the amount of information obtained, the greater the illusion of control. When learning new information, people place too much emphasis on how extreme or important it is. Too little emphasis is placed on validity or accuracy. Much of the information received is really noise and is not important – a lot of what we call information is inaccurate, hearsay, or simply outdated. Infact, some “information” used by investors these days is really an info-bomb. As illustrated earlier, information does not necessarily lead to knowledge or understanding.

• Active Involvement

The more people participate in a task, the greater their feeling of being in control. People feel like they have a greater chance of winning a coin toss if they flip the coin. Modern investors have high participation in the investment process. Investors using discount brokers must conduct their own investment decision-making process – they must obtain and evaluate information, make trading decisions, and then place the trades. This is surely an example of active involvement.

Overconfidence and Investing

Investing is a difficult process. You have to gather and analyze information and then make decisions based on that analysis. However, overconfidence causes you first to misinterpret the accuracy of the information and then to overestimate your skill in analyzing it. This can lead to poor investment decisions, which often manifest themselves as excessive trading, risk taking, and, ultimately, portfolio losses.

Look are your last trades. Are you an overconfident investor?

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