Overconfidence

Overconfidence is the tendency to overestimate your own knowledge, skill or ability to predict outcomes. Surveys repeatedly find that most people rate themselves as above average drivers, which cannot be true for everyone. Traders are no different. Overconfidence leads to trading too often, taking positions that are too large and holding on when the evidence says you are wrong.

The research#

In a 2001 study titled "Boys Will Be Boys", Brad Barber and Terrance Odean examined tens of thousands of brokerage accounts and found that men traded about 45% more than women. The extra trading reduced men's net returns more than women's, a result the authors attributed to overconfidence. The broader finding across their research is consistent: individual investors who trade the most tend to earn the least after costs. See Overtrading.

Forms of overconfidence#

When overconfidence strikes#

Overconfidence is most dangerous after success. A winning streak, a big trade or a strong month makes risk feel smaller and skill feel larger. Traders then increase size, loosen rules or move into unfamiliar markets, right before the normal losing streak that every strategy has. See Losing and Winning Streaks.

Warning signs#

• Increasing position size because you "feel good" about a trade.
• Skipping your checklist or journal.
• Trading new markets or instruments without study or practice.
• Dismissing contrary evidence. See Confirmation Bias.
• Talking about trades as certainties rather than probabilities.
• Attributing every loss to bad luck or manipulation.

How to stay grounded#

1. Keep risk rules fixed, regardless of recent results. See Position Sizing.
2. Judge skill on large samples, not a few weeks. See Statistical Significance in Trading.
3. Track your forecasts: write down your probability estimate for each trade and compare it with outcomes over time. Well calibrated traders' 70% calls win about 70% of the time.
4. Review losses as seriously as wins. See Post-Trade Analysis.
5. Learn new instruments on paper before trading them live. See Paper Trading.
6. Remember that markets are mostly noise in the short term. Even excellent traders lose often.

Confidence vs overconfidence#

Confidence is needed to take trades and follow a plan through drawdowns. It comes from evidence: a tested strategy, a consistent process, a large sample of results. Overconfidence comes from feelings, usually after recent wins. The test is whether your belief would survive a look at your full trading record.

Common mistakes#

• Sizing up after a hot streak.
• Believing past success guarantees future results.
• Treating forecasts as facts.

Frequently asked questions#

What is overconfidence bias in trading?#

Overestimating your skill, knowledge or forecasting ability, which leads to excessive trading, oversized positions and ignoring risk.

How does overconfidence affect returns?#

Research on brokerage accounts links overconfidence to more frequent trading, and more trading to lower returns after costs.

How can I avoid overconfidence?#

Keep risk rules fixed, judge skill over large samples, track forecast accuracy and review losses honestly.

Next, learn a classic error about probability: the Gambler's Fallacy.

Sources#

• Barber, B. and Odean, T., Boys Will Be Boys: Gender, Overconfidence, and Common Stock Investment, Quarterly Journal of Economics, 2001. Summary: Wikipedia, Overconfidence effect