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The risk of overconfidence bias when managing your portfolio

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Overconfidence bias is a bias in which people demonstrate unwarranted faith in their own intuitive reasoning, judgements and/or cognitive abilities. This overconfidence may be the result of overestimating knowledge levels, abilities and access to information.

For example, people generally do a poor job of estimating probabilities; still, they believe they do it well because they believe that they are smarter and more informed than they actually are. This view is sometimes referred to as the illusion of knowledge bias. Overconfidence may be intensified when combined with self-attribution bias.

Self-attribution bias is a bias in which people take credit for successes and assign responsibility for failures. In other words, success is attributed to the individual’s skill, while failures are attributed to external factors.

Consequences of overconfidence bias

As a result of overconfidence bias, investors may do the following:

  • Underestimate risks and overestimate expected returns
  • Hold poorly diversified portfolios
  • Trade excessively
  • Experience lower returns than those of the market

Overcoming overconfidence bias

Investors should review their trading records, identify the winners and loser and calculate portfolio performance over at least two years. Investors with an unfounded belief in their own ability to identify good investments may recall winners and their results but underestimate the number and results of their losers. A conscious review process will force them to acknowledge their losers, because a review of trading activity will demonstrate not only the winners but also the losers. This review will also identify the amount of trading.

When investors engage in too much trading, they should be advised to keep track of every investment trade and then calculate returns. This exercise will demonstrate the detrimental effects of excessive trading. Because overconfidence is also a cognitive error, more complete information can often help investors understand the error of their ways.

It is critical that investors be objective when making and evaluating investment decisions. There is an old Wall Street saying, ‘Don’t confuse brains with a bull market’ that warns about self-attribution. It is advisable to view the reasoning behind and the results of investments, winning and losing, as objective about their own behaviour. This can lead to self-attribution and overconfidence biases and result in repeating the same mistakes: overtrading and chasing returns to the detriment of actual realized returns.

To stay objective, it is a good idea to perform post-investment analysis on both successful and unsuccessful investments. When did you make money? When did you lose money? Mentally separate your good money making decisions from your bad ones. Then, review the beneficial decisions and try to discern what, exactly, you did correctly. Did you purchase an investment at a particularly advantageous time based on fundamentals, or did you luck out by timing a market upswing? Similarly, review the decisions that you categorized as poor. Did you make an investment aptly based on fundamentals and then make an error when it came time to sell, or was the market going through a correction? When reviewing unprofitable decisions, look for patterns or common mistakes that perhaps you were unaware you were making. Note any such tendencies that you discover, try to remain mindful of them by brainstorming a rule or reminder such as ‘I will do X in the future’ or ‘I will not do Y in the future.’ Being conscious of these rules will help overcome any bad habits you may have acquired, and it can also reinforce your reliance on strategies that have served you well.