Reducing overconfidence in traders
Overconfidence is widely documented in psychological research and in financial research for traders. Trading decisions often flummox researchers when it comes to human decision-making and logical market models. Overconfidence in trading is often linked to biased self-attribution i.e. our knowledge and decisions are responsible for the outcome and as we all know, we can’t predict the markets.
Traders need confidence in order to be able to make fast paced decisions and risk money in the trading environment. But overconfidence and been demonstrated to lead to entering more trades than necessary and for some, leading to bigger losses.
Who suffers with overconfidence?
Any trader can be overconfident. But research has shown that quite often, the people are the most sure of themselves are those who are the least competent, whereas those who are the least confident tend to be the most competent– The Dunning-Kruger Effect. Although not trader specific, you’ll see how this theory can apply to traders, particularly novice traders who are full of excitement and enthusiasm to put their learning into practice and think they know it all already, or traders who haven’t been making it along the way and keep going because they know that the next trade could be the one that makes them rich even though they are making more losses than profit.
This notion is backed up by research. In 2004 Markus Glaser and Martin Weber found that investors who think they are above average in investment skills or on past performance trade more.
Bruno Biais, Denis Hilton and Karine Mazurier (2005) found that miscalibration (over estimating the precision of information) influenced traders to underestimate the conditional uncertainty of asset value and left them vulnerable to the winner’s curse. Their research shows that miscalibration reduces trading performance whereas self-monitoring enhances TRADING PERFORMANCE. Interestingly, these psychological variables are non-existent for women, according to their research.
When does overconfidence occur?
Over confidence occurs when people focus on their first ‘guess’ or ‘spot’ and ignore other information. This is called option fixation. So traders will go with the first trade set up they see and may ignore information about that trade, such as strong indicators not to take it or a trade that doesn’t meet their strategy. It also occurs because humans are all too easily satisfied with their own explanations and decisions.
How can overconfidence be managed?
Sieck et al researched overconfidence in students on financial decision-making and looked at ways to reduce over-confidence. The main method used was to encourage people to think about questions and options separately and individually. So if you have a choice between ‘a’ and ‘b’, then you examine each choice individually and write down your explanation behind the decision. They found this method to be very effective because it stops individuals fixating on their initial answer. Writing down how you came to a decision stops you from fooling yourself as to how superficial your decision-making is or how influenced you are by overconfidence bias.
Look at the trade set-up in front of you and the question ‘do you take the trade or do you not take the trade?’
Examine option A ‘take the trade’
Assume you have found option A to be the best option. Explain why this is the best choice
Examine option B ‘don’t take the trade’
Assume you have found option B to be the best option. Explain why this is the best choice
Looking at both, which is the best option?
Obviously this is a convoluted method for live trading. But if you know you are over confident and guilty of entering too many trades then give this method a try and see how it effects your trades and give yourself the chance to change your behaviour.
Affirmations for balancing your confidence – use these daily
I am a confident trader who makes decisions based on the appropriate information
I enter all trades knowing that I can justify my decisions
I know that I enter only trades that meet my trading criteria
When I see a trade that tempts me but is not part of my trading plan, I am confident enough in my skills to let that trade pass.
Self-hypnosis – use this daily!
Look at this guide to self-hypnosis on Youtube. When you are in your Trader HQ, really visualise yourself following the process outlined above and imagine your brain going from learning the process, to being able to do it automatically for every trade so you instantly analyse the trading decisions you make.
If you need more support balancing overconfidence or indeed a lack of confidence in trading then have a look at my Skype trading coaching and book a free conversation with me. Email email@example.com
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