Saturday, April 26, 2014

Overcoming Overconfidence in Trading

One of the great challenges of trading is the fact that confidence is necessary to produce meaningful returns, and yet overconfidence can ensure catastrophic returns.  In that respect, traders and investors can be their own worst enemies, as we seem to be hardwired to perceive ourselves in unrealistically optimistic ways.  

Imagine giving a survey to traders in which they had to rate their skills on a five-point scale, where 1 = much below average; 2 = below average; 3 = average; 4 = above average; and 5 = much above average.

I strongly suspect that the average trader does not view himself or herself as average--just as few people rate their driving skills as average.  (Indeed, 82% of drivers rate themselves in the top 30%). 

One study showed that more than one third of investors who believed they had beaten the market had actually underperformed by 5% or more.  On average, investors in that study overestimated their performance by over 11%!  

How can market participants be so unrealistic in their self-assessments?  One set of experiments gave subjects tests in a variety of areas, including logic, grammar, and humor.  Those who scored in the bottom quartile averaged scores in the 12th percentile, but estimated their performance to be in the 62nd percentile.  The authors suggest this to be particularly problematic for non-experts and beginners in a field, as they lack the metacognitive ability to stand apart from themselves and objectively gauge their performance.

One characteristic I've noticed among successful traders:  they are their own hardest critics.  They avoid overconfidence by focusing on what they could be doing better.  If you read their journals, there are few excuses and emotional outpourings.  Instead, there are hard-nosed observations about what they did wrong and what they need to do better.

And how about the less successful traders?  Do they keep journals with rose-colored glasses?


They don't keep journals.

Which may enable them to sustain overconfidence.

Further Reading:  Keys to Goal Setting