Saturday, 29 September 2018

Psychology and Investing: Overconfidence

Overconfidence refers to our boundless ability as human beings to think that we are smarter or more capable than we really are.

Such optimism isn't always bad.  Certainly we would have a difficult time dealing with life's many setbacks if we were die-hard pessimists.

However, overconfidence hurts us as investors when we believe that we are better able to spot the next Microsoft than another investor is.  Odds are, we are not.

Studies show that overconfident investors trade more rapidly because they think they know more than the person on the other side of the trade.  Trading rapidly costs plenty and rarely rewards the effort.  Trading costs in the form of commissions, taxes, and losses on the bid-ask spread have been shown to be a serious damper on annualized returns.  These frictional costs will always drag returns down.

One of the things that drive rapid trading, in addition to overconfidence in our abilities, is the illusion of control.  Greater participation in our investments can make us feel more in control of our finances, but there is a degree to which too much involvement can be detrimental, as studies of rapid trading have demonstrated.

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