2/9/2024

How to Avoid Overconfidence in Trading

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Excessive self-confidence is a cognitive distortion that can lead to serious investment problems. It clouds the mind, causing us to overestimate our knowledge and skills. As a result, we are prone to making mistakes that lead to financial losses.

Remember, a smart investor is not one who is always right, but one who knows how to learn from his mistakes and constantly improves. Avoid the trap of overconfidence and your investments will bring you a steady income.

How to define overconfidence?

It is expressed in the fact that a person overestimates his abilities, knowledge and skills in a certain area. A person is confident that he can completely control the situation, even when this is not the case. People tend to overestimate their chances of success and underestimate their chances of failure.

Our natural tendency toward overconfidence makes our judgments vulnerable to cognitive biases. In finance, this leads to serious problems. Thus, this is one of the main mistakes when making investment decisions.

Believing in our own infallibility prevents us from realizing how susceptible we are to error and prejudice. We do not admit our mistakes, preferring to blame others or circumstances.

What are the consequences of overconfidence:

  • Suboptimal investment decisions. We invest in risky assets without recognizing the potential threats.
  • Missed opportunities. Failure to see alternative options causes us to pass up lucrative offers.
  • Financial losses. At its worst, overconfidence can lead to serious losses and even collapse.

Overconfidence Bias in Trading

The ability to read market trends is an invaluable skill in the world of finance. Many investors, traders and even analysts believe that their ability to predict market movements is above average. However, as statistics show, for most of them this is not the case.

The danger of overconfidence is that it leads to risky decisions, to taking larger positions in the market, and, as a result, to faster losses.

Why?

  • Confidence in being right prevents you from admitting mistakes in a timely manner and correcting your course.
  • Frequent trading increases transaction costs and reduces profitability.
  • Underestimating risks leads to unnecessarily risky investments.
  • Creating undiversified portfolios increases potential losses.
  • Ignoring warning signs out of confidence that things will stay the same.

Research has shown that overconfident investors trade more often, which negatively impacts their returns.

How to Avoid Bias in Trading

Don’t just rely on your own opinion. Consult other people: financial advisors, experienced investors, friends and family members. Seek different points of view – study various studies, news and analysis. Pay special attention to conflicting opinions – they can help you see your ideas from a different perspective.

Continuously learn. Follow market trends: read news, articles, blogs and books about finance. Explore new investment opportunities and improve your financial literacy – attend courses, webinars and seminars.

Focus on risk management. Diversify your portfolio – don’t put all your money in one asset – create a contingency plan.

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