Overconfidence is best illustrated by this survey of car drivers where 80% of the respondents rated themselves as above-average drivers.
Of course, statistically it’s impossible for 8 persons out of 10 to be above-average. I’m sure you won’t be surprised to learn that a similar survey carried out among investors produced similar results.
Excessive trading
Studies in behavioral finance show that investors who are overconfident, tend to trade excessively. Because they had a few profitable trades, they extrapolate and think they can consistently beat the market.
For example, if they trade in and out of a stock and make a gain of $200 in one day, they will extrapolate and think they can make $50,000 annually in trading profit since there are 250 trading days in a year.
Overconfident investors typically think they have something unique. They think they have the magic trading system or something special that other traders don’t have. They usually act on gut feeling or by looking at charts.
Cannot make the distinction between skill and luck
Many investors who bought shares in Internet companies during the dot com mania thought they knew what they were doing. They buy a stock based on a hot tip at a cocktail party, the stock goes up in price by 10% the next week and suddenly, they see themselves as expert investors.
Somehow, luck never enters the picture for them. It’s as if I go to the casino and win 5 black jack hands in a row; it doesn’t make me a professional card player. Even if I win 10 or 15 games in a row, it still doesn’t make me a professional card player.
Overconfident investors who jumped on the Internet bandwagon equated their short-term success to their stock-picking skills, yet they were just buying into a giant ponzi scheme.
All ponzi schemes without exception collapse sooner or later as new buyers stop joining the game. It’s the basic law of supply and demand.
Prices rise as demand increases and supply is short. As demand decreases, there is excess supply and prices fall.
If you strive to be a successful investor, being humble will take you much farther. That's because you will invest according to your level of knowledge and as a result will not take unnecessary risks.
Warren Buffett calls this investing within your circle of competence.
Related posts:
Most Common Investing Mistakes - Part 2 (Following the Crowd)
Most Common Investing Mistakes - Part 3 (Focusing on Price Instead of Value)
Of course, statistically it’s impossible for 8 persons out of 10 to be above-average. I’m sure you won’t be surprised to learn that a similar survey carried out among investors produced similar results.
Excessive trading
Studies in behavioral finance show that investors who are overconfident, tend to trade excessively. Because they had a few profitable trades, they extrapolate and think they can consistently beat the market.
For example, if they trade in and out of a stock and make a gain of $200 in one day, they will extrapolate and think they can make $50,000 annually in trading profit since there are 250 trading days in a year.
Overconfident investors typically think they have something unique. They think they have the magic trading system or something special that other traders don’t have. They usually act on gut feeling or by looking at charts.
Cannot make the distinction between skill and luck
Many investors who bought shares in Internet companies during the dot com mania thought they knew what they were doing. They buy a stock based on a hot tip at a cocktail party, the stock goes up in price by 10% the next week and suddenly, they see themselves as expert investors.
Overconfident investors who jumped on the Internet bandwagon equated their short-term success to their stock-picking skills, yet they were just buying into a giant ponzi scheme.
All ponzi schemes without exception collapse sooner or later as new buyers stop joining the game. It’s the basic law of supply and demand.
Prices rise as demand increases and supply is short. As demand decreases, there is excess supply and prices fall.
If you strive to be a successful investor, being humble will take you much farther. That's because you will invest according to your level of knowledge and as a result will not take unnecessary risks.
Warren Buffett calls this investing within your circle of competence.
Related posts:
Most Common Investing Mistakes - Part 2 (Following the Crowd)
Most Common Investing Mistakes - Part 3 (Focusing on Price Instead of Value)
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