Beware: Investor Overconfidence Can Trap You

4 Illusions That May Impair Your Investing Decisions

Beware! Your mind can play tricks on you as you progress toward decisions on buying and selling securities. Your well-thought-out plan may in fact be prone to faulty perceptions that you may act on over and over again.

Let’s concentrate on the bigger picture for a moment. The following chart demonstrates a basic concept: What we think we see can be incorrect.

In the first image, the two circles are exactly the same size. In the second image, the two gray bars are of identical length. In the third image, the orange horizontal lines are straight, not crooked. Our initial perceptions may be illusions.

Here are some of the more common behaviors that can lead to irrational decisions:

  • Confirmation Bias
    This occurs when people look for information that confirms their beliefs rather than the information that might disprove them. Before making a reasoned decision, a trader or investor should consciously look for disproving evidence.
  • Gambler’s Fallacy
    We can wrongly project that probabilities will revert to long-term averages. Here’s an example: A coin flip has produced 5 heads in a row. We project that tails is the most likely outcome of the sixth flip. This is incorrect. The odds remain 50/50.
  • Availability Bias
    This occurs when we give greater weight to information about a security that is more accessible or readily recalled. Traders and investors should take a step back and look at the big picture, rather than making a decision based on what’s currently happening.
  • Disposition Effect
    We can have an emotional aversion to taking a loss in a security even when doing so might be the best decision. On the other side, we can tend to sell winners simply because they have made profits, possibly missing out on future gains.

Impact on Investing and Trading

Similar biases are prevalent among traders and investors as well. According to Dalbar Inc., a financial services market research firm, behavioral biases have led to poor portfolio decisions.

According to a Dalbar study, the average stock fund investor recorded a 4.67% return over a 20-year period (1996-2015) compared with the 8.19% increase in the S&P 500 over the same period. The difference largely comes because investors jumped in and out of the funds at the wrong time. Many panicked and sold at low prices as the market fell, and they were late to buy as the market recovered. In other cases, they attempted to time the market and missed.

“These biases are leading people to the ultimate trap in managing their portfolio – they’re buying high and selling low,” said Joe Correnti, senior vice president of brokerage product at Scottrade. “They’re moving in and out of the market, where sticking with their plan would have served them well.”

How to Fight Irrational Behavior

By identifying illusions, we hopefully are better able to counteract them.

Overconfidence can also lead to irrational decisions. Morningstar defines it as “rating oneself as above average when it comes to selecting investments” and suggests that it has the following implications:

  • Miscalculating the probability of good outcomes
  • Focusing on the potential upside of investments
  • De-emphasizing the potential downside of investments

How easy is it to fall into the trap of investor overconfidence? When people are asked to rate their driving ability, studies show that 80% to 90% of respondents consider themselves to be above average. Of course, on a statistical basis, this is impossible.

“The market can teach humility in a hurry,” Correnti said. “Knowing this going in, and recognizing the biases we may hold, may lead to more careful and reasoned investing and trading decisions.”

Read Next: Evaluating Winning and Losing Investments

The content provided is for informational and/or educational purposes only. The information presented or discussed is not, and should not be considered, a recommendation or an offer of, or solicitation of an offer by, Scottrade or its affiliates to buy, sell or hold any security or other financial product, or an endorsement or affirmation of any specific investment strategy. You are fully responsible for your investment decisions. Your choice to engage in a particular investment or investment strategy should be based solely on your own research and evaluation of the risks involved, your financial circumstances, and your investment objectives. Scottrade, Inc. and its affiliates are not offering or providing, and will not offer or provide, any advice, opinion or recommendation of the suitability, value or profitability of any particular investment or investment strategy.

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