Overconfidence, Emotion and Reasoning

Overconfidence

Overconfidence can lead investors to excessive trading and risk taking. There are two aspects of overconfidence: miscalibration and better-than-average effect. Miscalibration means being ignorant of some of the likely outcomes. Better-than-average effect is when people consider themselves better than average, which cannot be true for everyone. Since people tend to believe that success is attributed to skill and failure is caused by bad luck, small successes in the market may cause investors to become overconfident

Emotions

Price bubbles are not uncommon. One of the most famous ones was the Tulip Mania, which occurred in the Dutch Golden Age. At its peak in 1637, a single tulip bulb sold for more than 10 times the annual income of a skilled craftsman. The bubble burst much more quickly than it was formed. When people started to refuse to honor their transactions, the sentiment turned so quickly that the price plummeted to nothing almost overnight.

Although it’s difficult to defy human nature, we can teach ourselves to avoid some of the abovementioned errors by following a systematic approach to investing. Have a look at our previous blogs, such as Building a Financial Model and Developing a Stock Trading Strategy. After finding an investment style that best suits you, it’s important that you follow through. Use risk management and diversification instead of a goal-based approach, and have a quantitative investment criteria instead of relying on emotions. Memory is often unreliable, so remember to keep a precise and accurate record. Perhaps it helps to write down a few rules of thumb where you can see them, such as: avoid trading too frequently, monthly check on stocks, annual review of portfolio and make necessary adjustments based on risk appetite, etc. To remind yourself to think analytically instead of intuitively, one of the best books to read is Daniel Kahneman’s “Thinking, Fast and Slow”.

Heuristic Simplification

People use mental shortcuts to quickly organize and process large amounts of information. This process is called heuristic simplification. Two examples are representativeness and familiarity. Representativeness bias causes people to assume good companies are good investments, and believe that past good performances will last into the future. Familiarity bias causes people to stay close to what they are familiar with. They judge familiar stocks with too much optimism and unfamiliar stocks with too much pessimism, leading to lack of diversification and false sense of risk.

Short-term Focus

As long as we have access to a news outlet, whether it’s the newspaper or the internet, we are constantly flooded with financial news. Our investment activities tend to be influenced by the media and other professional investors. The problem is, people sometimes react too quickly and commit mistakes when they lose sight of the long term.