An investor should play his own devil’s advocate during stock selection to avoid being overconfident.
In finance literature, investors in general are considered risk averse. Risk aversion implies that though investors dislike risk, they are willing to assume risk if adequately compensated in the form of higher expected returns. Contrary to the above, there is another set of investors who are known as overconfident investors. If investors are overconfident, they place too much emphasis on their ability to process and interpret information about a security. Overconfident investors do not process information appropriately. Let us see whether you are an overconfident investor, and if yes, what are the ways to control the same.
Overconfidence is actually a kind of bias in which you have too much faith in the precision of your own estimates, causing you to underestimate the range of possibilities which actually exist. In this process, you might underestimate the degree of possible losses, and therefore, underestimate investment risks. Overconfidence also comes from the tendency to attribute good results to good investor decisions and bad results to bad luck or bad markets.
In the context of investing, overconfidence can manifest itself in over-trading or switching between investments very often in order to increase returns. Each has its own negativities. For instance, over-trading can have a detrimental effect on your portfolio because it creates a tendency to sell loss-making shares at low prices and to buy profit-bound shares at high prices. Of course, over-trading can also lead to high brokerage costs, high capital gains tax liabilities and the possibility of selling out of the market just when investment performance rises. Empirical evidence also confirm that overconfidence among investors can lead to excessive trading. In the process of excessive trading, you tend to buy stocks actually performed worse on average than that the ones which you have sold. In other words, investors who traded more tended to make more mistakes. This kind of behaviour can also affect long-term savers.
How to manage overconfidence
Look for indicators: Certain behaviours should raise a concern. One such sign is over-trading, which you can measure by carefully keeping track of your investment returns and brokerage costs. Second is market timing, an investment tactic based on buying or selling shares in anticipation of changes in market or economic conditions. Actually, market timing-based investment will not provide higher returns than that of maintaining buy and hold strategy.
Have realistic expectations:Certain investments have the potential for high returns because they entail quite a bit of risk, which means you can lose money as well as make money on them. Knowledge of the historical performance for different types of investments can help you establish an asset allocation that’s appropriate and realistic for your goals. For instance, during a bull market phase, some people began to think that they could make an yearly stock returns of 20% to 30% which is much higher than historical averages. To keep your expectations for returns realistic, you should understand that past performance for any investment is not indicative of future returns. Learn about the historical average returns for specific investments. It pays to be a realist instead of being overconfident.
It is difficult to negate your own opinions while investing in stocks. Because we always have the point in our mind which says that ‘how can I be wrong’? We all humans suffer from a psychological bias called self-attribution. When things go well, we attribute the results and success to our own actions. But when things don’t go our way, we start blaming bad luck. People who are overconfident will tend to trade more, follow herd mentality, and ignore lessons from previous mistakes. So, play your own devil’s advocate during the stock selection process to avoid being overconfident.
All you need to know
* Overconfident investors might underestimate degree of possible losses, and so undermine risks
* In investing, overconfidence can manifest itself in over-trading or often switching between investments
* Over-trading can lead to high brokerage costs, high capital gains tax liabilities and the possibility of selling out of market
* To keep returns expectations realistic, one should realise investment’s past performance doesn’t indicate future returns
** The writer is associate professor of finance & accounting, IIM Shillong