Overconfidence

Trading is a very difficult job, not only because of the technical requirements but also because of the mental toughness and discipline it requires. In this article I'm going to talk about the role of overconfidence and how it can damage newcomers and experienced traders alike.

1. What is Overconfidence?

To illustrate the point at hand, here is an example. In a confidence-intervals task, subjects had to judge quantities such as the total egg production of the U.S. or the total number of physicians and surgeons in the Boston Yellow Pages. The subjects expected that they could get a 98% accuracy on their answers. The real accuracy rate was 54%. Once subjects had been thoroughly warned about the bias, they still showed a high degree of overconfidence. This is quite similar to the situation in trading, where an inordinate amount of people attempt to “beat the market” by trading their own funds, knowing that over 90% of newcomers blow 90% of their account in 90 days. It's the “90-90-90 rule” which many forex brokers and dealers cite. Tom Cargill of Bell Labs would be fascinated by this pearl. Yet, the inflow of would-be traders continues, despite the warning.

But for the sake of this article, we're going to talk about traders that have found their footing and that have a set of rules to follow. Yes: experienced traders can fall into the overconfidence trap just like newcomers...but in another fashion. Experienced traders are much more likely to overtrade relative to newcomers, that are more prone to analysis paralysis. So how do you know you're overtrading?

Signs of overtrading...
Source: http://www.ellen-may.com/v2/images/stories/overtrade%202.jpg
2. Being confident vs. being Overconfident

There's no doubt that self-esteem and feeling good about ourselves is positive and can help us progress through our life. But there's a difference between being confident and falling into overconfidence. If we want to improve our trading for example, we need to consider the impact that constructive criticism can have on us – we need to be able to admit that we can actually be wrong! Overconfidence can also lead us to make decisions without properly considering that things might not go according to plan.

In particular, overconfidence can lead to overtrading. And overtrading is hazardous to your health and your wealth! Lets start with something funny, to understand what overtrading is: when I was working as a broker, I had a client that would call in 120 times/day on average and trade GbpJpy (a 300 pip mover back in the day). Here is how the conversations would go:

“good morning AGAIN, the market is just where you left it...nothing major to report. You can go ahead with your business day and if something pops up, I'll call you later”

“Good morning again...hey why don't we exchange jobs? Seems like you've got a lot of spare time! The markets are just where you left them...nothing interesting going on today...i think you can really relax today and take a breather..”

Overtrading comes in the form of a near obsession in trading any/all news-based surprizes (to the upside and downside) being confident that you have the ability to understand the reaction perfectly, and by chart gazing (i.e. staring at charts long enough to “find an entry”).  To find out if you're prone to overtrading, try to answer these questions:

1. Do you find it difficult to not be in a trade?

2. Do you find that you're unable to remove yourself from the computer after entering a trade, or that it is very difficult to do so?

3. Do you exceed your daily drawdown limit?

4. The minute your trade goes into profit, do you want to move your stop to breakeven? (trading your equity instead of the market)

3. The Turnover Test

The "Turnover Test" is a famous study which arranged real investors into five groups according to the proportion of their portfolio they turned over every month. The results shown below shows that group one barely traded at all, while group five changed nearly 25% of their portfolio every month (black bars).

Overconfidence can lead to overtrading. And overtrading leads to less accurate decision making, more transaction costs and more timing risk (as you are entering the market various times, hence leveraging your confidence in market timing abilities).


Source: Barcap.com
Bottom Line: trading really brings out the worst from us, so that we can see ourselves at our worst and work to change our habits and bring out the best of us. Bringing any kind of unjustified confidence into your trading habits will cost you a lot. Not just commissions, but actual losses in your trading account. Instead of trading like a sniper, waiting for the market to come to you, you will be shooting like a machine gunner, targeting anything and everything. Obviously, this is a recipe for disaster! So calm down, be humble, and realize that you cannot possibly know all there is to know about the market's uncerlying conditions at any point in time. Hence, uncertainty is always present and all you need is the confidence to act according to plan.

Good Luck!

References:

1. Haigh, M. S., & List, J. A. (2005). Do Professional Traders Exhibit Myopic Loss Aversion? An Experimental Analysis. Journal of Finance, 60(1), 523-534

2. Judgment under uncertainty: Heuristics and biases. Cambridge University Press. pp. 294–305.

3. http://en.wikipedia.org/wiki/Overconfidence_effect

4. Investor Overconfidence and Trading Volume, Meir Statman, Steven Thorley and Keith Vorkink, 2003