Overconfidence bias causes investors to overestimate their knowledge and underestimate risk.
In essence, overconfidence bias is a cognitive glitch that tricks us into thinking we’re better at predicting and assessing risk than we are. This bias, deeply rooted in our psychology, stems from our instinctive need to view ourselves as competent and in control. However, when investing, this natural bias can lead us off course.
The impact of overconfidence on investment decisions is significant. Overconfident investors may trade more frequently, believing they can time the market or pick the next high-performing stock. However, research indicates that excessive trading often results in subpar performance, mainly due to transaction costs and increased risk exposure. Overconfidence can also lead investors to hold a less diverse portfolio, mistakenly trusting in their ability to select only winners.
Adopting a long-term, strategic approach to investing can also counteract this bias. Instead of trying to single out winning stocks or time the market, focusing on broad diversification and long-term trends can yield more consistent returns. Having a firm understanding of each asset or investment’s role in this diversification is important, the diversification benefit is less clear than simply the assets return.
Overconfidence may be part of our natural disposition; however, it is vital to keep it under control when navigating the investment terrain.
