Overconfidence is the unwarranted faith in one’s intuitive reasoning, judgments, and cognitive abilities. Studies conducted have shown that people overestimate both their own predictive abilities and the precision of information that they have been given. In addition, people are poorly calibrated in estimating probabilities – events which they think are certain to happen are often less than 100% certain to happen.
In short, people think that they are smarter and have better information than they actually do. For example, they may get a tip from a broker or read something off the internet, and they’re ready to take action, such as placing a trade, based on the perceived knowledge advantage. If there is no logical basis for the advantage, then this perceived edge does not exist at all, despite what the trader thinks he knows.
There are two kinds of overconfidence – prediction overconfidence and certainty overconfidence. In prediction overconfidence, the confidence intervals that traders assign to their predictions are too narrow. An example of this is when gurus try to forecast precise price targets. In certainty overconfidence, traders are too certain of their judgments. For example, after entering a “sure-win” trade, traders become blind to the prospect of a loss, and then feel disappointed or surprised that the trade performs poorly. Always keep in mind that trading is a game of probabilities, and nothing is 100%.
How does this affect your trading?
The dangers of overconfidence are numerous. For example, if traders overestimate their ability to pick a winning trade, they become blind to warning signs or information that indicate that their decision was wrong. This might make them enter bad trades or hold on to losing positions. If traders believe they have special knowledge, they may also end up trading excessively. Overconfidence can also cause traders to underestimate downside risk, and in worse cases not using a stoploss.
“Too many people overvalue what they are not and undervalue what they are.”
– Malcolm S. Forbes