What is overconfidence?
Overconfidence is thinking too well of ourselves: we don’t know as much as we believe, and our guesses are not as precise as we think. It is not about arrogance; nearly everyone has some of it.
In a 1981 study by Swedish psychologist Ola Svenson, 93% of the US participants rated themselves as more skilful drivers than the median driver, and 69% in Sweden. By definition, at most half of people can be above the median.
Say Tanvir bought shares for the first time during a booming market, and within a few months all three of his picks were well up. He thought, “I’m good at picking.” Yet at the time most shares in the market were rising. The next year he put a large part of his savings into one share and started trading often. The real mistake was not separating luck from skill. The story is only an example.
Why it matters to an investor
- Trading too much: people who trust their own forecasts trade often, and commission and other costs are taken every time.
- Too little diversification: putting a lot of money into a few shares because “this one is sure to rise”, so one bad result hits hard.
- Underestimating risk: thinking too little about what could go wrong, and taking risks like borrowing to invest.
- Mistaking luck for skill: in a rising market almost everyone makes money, so it is easy to draw the wrong conclusion about your skill from a few good picks.
Three forms of overconfidence
- Overestimation: thinking our knowledge or results are better than they are. For example, remembering your portfolio’s return as higher than it really was.
- Over-placement: “others make mistakes, I won’t.” The driver study is an example of this.
- Over-precision: forecasting the future within too narrow a range, such as “in six months the price will be between Tk 80 and Tk 85”, when the real uncertainty is far wider.
More trading, lower returns
Economists Brad Barber and Terrance Odean analysed the trading of 66,465 households at a large US discount broker from 1991 to 1996. The average household turned over about 75% of its portfolio each year. Those who traded the most earned an annual return of 11.4%, while the market returned 17.9%.
Their explanation: trading costs and overconfidence. People believe their information or judgement is good enough to cover the cost of trading, but on average it is not. The period, country and market are different, but the logic that every trade has a cost applies in Bangladesh too.
Source: Barber & Odean, Journal of Finance, 2000
See the numbers as a table
| Return a year | |
|---|---|
| The market | 17.9% |
| Most active traders | 11.4% |
Habits for checking yourself
- Keep an investment diary: what you bought, why, and what you expect. Later, check how many of your guesses came true.
- Measure your own return honestly, after all costs, and compare it with a simple benchmark such as the market index.
- Before buying, ask: “If this goes badly a year from now, what is the most likely reason?”
Worked example
- Say your portfolio is worth Tk 2,00,000. Each buy or sell costs 0.5% in commission and other charges (a hypothetical rate; check your own broker’s actual charges).
- You switch the whole portfolio six times a year: six sells and six buys, 12 transactions in all.
- Cost = 2,00,000 × 0.5% × 12 = Tk 12,000, or 6% of the portfolio.
Result: just to cover costs, your picks must earn an extra 6% a year. Someone who buys once and holds pays about 1%. The more you trade, the bigger the bet on your own skill. The numbers are only an example.
Common mistakes
- Taking profits in a booming market as proof of skill, without checking how much the market itself rose.
- Remembering only the good picks and writing off the bad ones as “bad luck”.
- Trading often without adding up the costs of trading.
- Being “sure” and putting a large part of your savings into one or two shares, or borrowing to invest.
Write down your forecasts and check them later: your own record is the most honest mirror for overconfidence.