Cognitive Bias – Overconfidence

  • February 26, 2022
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Cognitive Bias - Overconfidence

Cognitive Bias – Overconfidence

“Be wary, for overconfidence is a slow and insidious killer.” – Dark Dungeon

Overconfidence is a cognitive bias that can influence investing decisions in the stock market. Overconfidence occurs when one’s belief in one’s ability (subjective), exceeds reality (objective).  It refers to the tendency of individuals to overestimate their abilities, knowledge, or the accuracy of their predictions, leading them to take excessive risks or make poor investment decisions.

Here are five key points to understand about overconfidence when investing in the stock market:

1. Illusion of control:
Overconfident investors may believe they have more control over their investments than they actually do. They may have a false sense of certainty that they can accurately predict market movements or pick winning stocks, leading them to take on excessive risks. This can result in impulsive buying or selling decisions based on gut feelings or incomplete information, rather than a rational investment strategy.

2. Confirmation bias:
Overconfident investors may seek out information that confirms their existing beliefs or opinions, while ignoring or downplaying contradictory information. This confirmation bias can reinforce their overconfidence, leading them to overlook potential risks or warning signs. It can also limit their ability to objectively assess the performance of their investments and make necessary adjustments.

3. Overestimation of skills:
Overconfident investors may believe they possess superior skills or knowledge compared to other investors. They may overestimate their ability to outperform the market or beat professional fund managers, leading them to take on higher risks or make concentrated bets on specific stocks or sectors. However, the reality is that stock market performance is influenced by a multitude of factors, many of which are beyond an individual investor’s control.

4. Overtrading:
Overconfident investors may engage in excessive trading, thinking they can time the market or take advantage of short-term fluctuations for quick profits. However, frequent trading can lead to higher transaction costs, increased taxes, and reduced returns due to market volatility. It can also result in poor decision-making based on emotional reactions to short-term market movements, rather than a long-term investment strategy.

5. Failure to diversify:
Overconfident investors may underestimate the importance of diversification, which is a fundamental risk management strategy in investing. They may overly concentrate their investments in a few stocks or sectors, believing they can accurately predict their performance. However, this lack of diversification can expose them to higher risks, as poor performance of a single stock or sector can have a significant impact on their overall portfolio.

Managing Overconfidence:
Overconfidence can lead to poor investment decisions in the stock market. It is important for investors to be aware of their cognitive biases and strive for rational decision-making based on thorough research, diversification, and a long-term investment strategy.  Attend Wealthwise Education’s ‘Invest for Success’ Program to learn how to make informed investment choices and avoid the pitfalls of overconfidence.

Stock Market Investor Education:
‘Invest for Success’ is a 4 week program starting with a 2 day in-person workshop + 4 x 1 hour online sessions over 4 weeks.  Call us now for more information +61.2.9488.9900.

Read more:  Top 5 Cognitive Biases Overview


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