How overconfidence affects trading?

Sometimes people tend to be overly optimistic about their life prospects, and this optimism directly influences their final decisions.

The tendency to overestimate yourself includes:

  • Inflated self-esteem in the population (in our case, among other traders).
  • Overestimating the accuracy of one's own beliefs.

 An example is overestimating your ability to predict the performance of the stock or foreign exchange markets.

The cognitive process that helps maintain these beliefs is biased, meaning that people trust their talents and abilities based on past successes, and they attribute failure to bad luck.

And here we can identify a pattern: the more often an arrogant investor is faced with overtrading, the more often he makes mistakes. But he is usually unable to understand their nature.

Case studies

Overconfidence among financial officials, some investors, retail traders, and even bankers can be documented.

Men are more self-confident than women in making decisions in areas, that are traditionally masculine, such as money. Overconfidence leads to increased trading volumes. The average turnover in accounts opened by men is about 1.5 times higher than in accounts opened by women, in line with a more pronounced degree of confidence on the part of men, and therefore men pay almost one percent more per year: and therefore higher transaction costs and their profitability minus commissions become much lower.

The 2021 study authors Daniel Walters and Philip Fairnbach contributed to the study of this issue.

A group of respondents was asked to recall their most significant trades and rate them and then compare them with the real situation. It turned out that many respondents are prone to bias positive memories.

To confirm this hypothesis, a sample of 411 people was created, about 30% of whom are women. They were given three tasks:

  1. Memory phase: recall two cases of 2019 that had the greatest impact on the respondent's investment portfolio;
  2. Frequency of trades: determine how often a person makes trades;
  3. Reporting: real numbers of cases mentioned in another phase.

It turned out that the investment had a higher value in the memory of the investor than it was.

At the second stage, already new participants were asked to recall 10 important investments in 6 months of 2020, as well as assess their potential in the next 12 months and compare with real indicators. The results turned out to be almost identical to the previous experiment.

The authors of the scientific work conducted only three polls, in the last of which they changed the order of actions: first, they published the reports, which reassured most of the participants. You can see the full text and statistics table here.

Conclusions:

  • Overconfident individuals are prone to selective memory and overestimation of results;
  • They trade more often, although they lose money;
  • They use a lot of leverage;
  • They tend to over-focus on the same familiar instrument.

From the point of view of trading psychology

If we consider this issue in the context of psychology, then even without research, we can come to the conclusion that the tendency to exaggerate our skills and knowledge often fails.

One of the manifestations of this trend is the neglect of a good risk strategy. When you are 300% confident in yourself, you can not diversify your portfolio and not set a stop loss, and with this approach, colossal losses will quickly overtake even the most experienced professional. 

Lack of development is also characteristic. Specialized literature, courses, selection, and optimization of new, more effective tactics allow you to go further and achieve more. But why strive for more for someone who does not doubt their professionalism?

Overconfident trading in the long term

You need to take a sober look at yourself to trade effectively and consistently make profits that cover inevitable losses. Overestimated self-esteem in combination with high claims negatively affects the results of trading: the trader loses the ability to rationally look at the situation and assume different outcomes.

Losses, as mentioned above, will be viewed through the prism of bad luck and coincidence, but over time, a person risks experiencing disappointment in the profession. This applies to any market: securities, digital assets, currencies, real estate, and metals. Behavioral factors are the same everywhere.

Who is to blame and what to do

You will be able to avoid many problems if you start to doubt yourself. It is important not to get scared here. Fear constrains and interferes with making potentially profitable decisions, forces you to follow the path of least resistance, and this option is no better.

The survey result, which we considered above, and other similar works show that it is important for a retail investor to look at himself adequately. And financial reporting helps a lot in this.

Equite allows you to take an unbiased look at your actions.

Only dry numbers are received directly from connected services. This helps to cope with high expectations, establish risk management and optimize the capital management process.

You can use the obtained data not only for personal obserуvations but also in your portfolio because nothing tells about you better than your achievements.

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