Beware of your own overconfidence when investing

Investing has become a very popular passtime. Stockbrokers have made it ridiculously easy for someone to sign up for a brokerage account and start trading immediately. More often than not, everybody has had the experience of doing their research, picking a stock and have it instantaneously starts rising. The problem is that we immediately start inferring that we must have some skill in our stock picking. What makes us jump at this conclusion so easily?Investing

You very rarely hear a “weekend warrior” investor say “my stock is only going up because the economy is doing well”. More often you will hear: “I just knew it was a good stock!”. If things go badly, you hear: “it is going down because the economy is bad”, rather than: “I was wrong”. This phenomenon is called “self-attribution bias” – taking personal credit for wins, but attributing losses to factors outside of our control. The stock markets are unpredictable. Self-attributing successes is a natural step to gain confidence in our investing abilities.

We are also susceptible to “Hindsight bias”. This means, if the stock does well, we say: “I knew it all along!”. This makes us even more confident in our abilities.

The terminal step is “the illusion of control”. “Illusion of control” is the tendency to think we can control the uncontrollable. We think: “The stock has gone up, therefore our information and logic are correct!” More confidence! Unfortunately, no matter how good we are, there are always situations in the business environment that cannot be forecast. No matter how much information you gather and complexity you add to your forecasting model, you can still be wrong.

Combine these three factors and we are ready to give Warren Buffett a run for his money. We start taking increasing risks and essentially gamble with our hard-earned money.

How do we control these biases?

The first step is to write down why you made any investment decision and all the ways you could be right or wrong in your reasoning. This will give you the ability to look at the investment process logically and make you aware of any reasoning before the fact, rather than in hindsight. In time you will be reminded by Mr.Market that there are many things outside your control and sometimes you are just plain wrong.

Investing is one of the most difficult disciplines to master. The trick in improving as an investor is to look at investment decisions logically and remove as much emotion as possible out of your decision-making.

Kevin Mzansi