4 Psychological Traps That Make Investors Overconfident

A group of friends are talking on a call, making plans for their Himachal trip:

Friend 1: "Bro, we’ll leave Delhi at 10 p.m. and reach Manali by 5:00 a.m."

Friend 2: “The distance from Manali to Delhi is a 10-hour journey; how are we reaching in 7 hours?”

Friend 1: “Don’t worry, bro! Your buddy drives like an F1 racer. I can handle dangerous roads so well that even Michael Schumacher would be impressed.”

Friend 2: “Bro, just make sure that even if Schumacher is not impressed, Yama (the god of death) doesn’t come to personally join us for the trip.

After all, confidence is good, but being overconfident isn’t! Also, we all have that one friend who’s like the prime minister of the land of overconfidence.”

“I have seven years of driving experience, so I can drive at 100 km/h on highways – that’s confidence. But saying I’ll drive at 100 km/h on mountain roads, despite never having done it before– that’s overconfidence. Although, there’s a small difference between the two, but that tiny difference often creates big problems. And this overconfidence isn’t just limited to driving; we show it in everything.”

“I’m so fit I can run 3 kilometres in 10 minutes anytime.”

“My skills are so strong that even if AI advances, I’ll always be in demand.”

“My analysis is so accurate that I’ll always make profits in the stock market.”

But often, this overconfidence and overestimation of our abilities lead us to make big mistakes, which can cost us heavily. When ego takes over, it pushes you to believe you’re superior to everyone else.

The FINRA Investor Education Foundation conducted research on younger, less experienced investors. It reported that almost two out of three investors rated their investment knowledge highly, but when tested, they were found to be not only uninformed but misinformed. Why? They were overconfident about their knowledge.

Ray Dalio, the founder of the world’s largest hedge fund, Bridgewater & Associates, once said, “I knew that no matter how confident I was in making any single bet, I could still be wrong.” But overconfidence doesn’t always stem from the belief that we always know everything about everything; it can stem from various reasons tempting us to make poor decisions.

In today’s article, we’ll discuss all those reasons:

1. The Dunning-Kruger Effect:

This phenomenon can lead novice investors to think they’re more knowledgeable and skilled than they really are. This can cause risky investment decisions and hefty losses. Overconfident investors tend to trade excessively, ignore risks, and often invest all their money in a single stock or asset class. Today, everyone has access to massive information and data thanks to YouTube, media outlets, and a range of investing tools. But relying on half-baked information often leads to poor returns and losses.

How can you overcome the Dunning-Kruger effect? Consume knowledge from credible sources that provide in-depth learning, maintain an investment journal to record every trade, the rationale behind it, and the outcome, and review it periodically to understand your decision-making patterns. Do your own in-depth research instead of relying on half-formed information or others’ opinions.

2. The Illusion of Control:

Imagine how many people invested in stocks in January 2020, thinking the market trend would stay steady for years. Many thought everything was going according to their plan. But within 2-3 months, everything flipped as COVID hit, and a lockdown led to a 35% market crash, pushing people who believed they were in control into a state of panic. Those under this illusion of control often think they can time the market and earn 5-10x returns overnight.

How to protect yourself from this illusion: Develop a checklist for making investment decisions, consult it each time you research, or buy/sell, so you don’t get carried away. Never assume you can predict future movements! Also, adopt a mind-set that will make you think on probabilities rather than certainties. By taking this approach you can evaluate the outcomes more realistically.

3. Luck vs. Skill conundrum:

When I first sat at the roulette table in Goa’s casino, I thought I’d cracked the code after a few wins. But by the end of the night, I lost all my winnings – and quite a bit of my bank balance. You see, nothing breeds confidence like success, but it is easy to think that you have developed a Midas touch after winning a few rounds. Even if that success is a combination of hard work and a bit of luck. There is a common saying, “A rising tide lifts all boats”. But as Warren Buffett says, “You will find out who’s swimming naked only when the tide goes out.”

The best way to counter this: Start embracing luck, as it will make you humble.

4. Hindsight Bias:

Many of us suffer from hindsight bias, convincing ourselves that we accurately predicted an event before it happened. When something goes well, we often say, “I knew this would happen,” inflating our confidence and making us feel our instincts are always right.

To overcome hindsight bias: Focus on small, consistent gains over the long run instead of aiming for occasional big hits. Forget what happened in the past; make decisions based on your current research and forecast.

These are proven ways to overcome overconfidence bias and ensure higher success in the stock market. Remember, overconfidence is like an addictive drug; you might enjoy it when it brings pleasure, but soon, you’ll be hooked, and there’s no coming back. So, cut it out of your life and the stock market before it causes destruction and losses.