Overconfidence

You can explain overconfidence, name the research that links it to frequent trading and lower returns, and check your own record honestly.

Better than average?

Ask a room full of drivers whether they drive better than average, and most will say yes. That cannot be true for most of them.

The same thing happens with trading. A few good trades, a strong opinion, a lot of time spent reading charts, and it is easy to feel that you have an edge. Research suggests that this feeling is common, and that acting on it can be expensive.

More trading, less return

Overconfidence is the tendency to overrate your own knowledge, skill or the precision of your predictions. In trading, it often shows as believing your information or timing is better than that of the other side of the trade.

Economists Brad Barber and Terrance Odean tested what this does to results. They analyzed the accounts of 66,465 households at a large US discount broker from 1991 to 1996.

The market returned 17.9% a year in that period.
The average household earned 16.4% a year.
The households that traded most earned 11.4% a year.

The most active traders did not lose because they picked worse stocks on paper. Much of the gap came from the costs of trading so often. The authors concluded that overconfidence can explain both the high trading levels and the poor performance. Their title sums it up: trading is hazardous to your wealth.

In a second study, the same authors used gender as a rough proxy for overconfidence, based on psychological research showing men are more prone to it. Men traded 45% more than women and earned risk-adjusted net returns 1.4 percentage points a year lower.

These studies describe averages, not every person. But they show a clear pattern: feeling confident is not the same as being right, and acting on confidence has a price.

Five wins is a small sample

A fictional trader starts with 10,000 and risks 100 on each trade.

The first five trades all win 120 each, for a profit of 600.
Feeling skilled, the trader raises the risk to 400 per trade.
The sixth trade loses 400. The seventh loses 400 too.

After seven trades, the account shows a loss of 200, even though five of the seven trades were winners. Five wins in a row can happen by chance quite often. It is not enough evidence of skill to justify a larger risk, but it feels like plenty. A fixed risk per trade, set before the streak, would have kept the loss of trades six and seven at 200 and the account in profit.

Common mistakes

Counting wins, forgetting costs. Only your result after all fees and spreads counts.
Raising size after a short streak. A few trades say little about skill.
Mistaking a rising market for skill. When everything rises, almost every buyer looks smart.
Never comparing. Without a benchmark, you cannot tell whether trading added anything.
Trusting precise forecasts. A price target to two decimals sounds certain. It is still a guess.
Ignoring luck in your own wins. Ask how many of them a coin flip could have produced.

The takeaway

Most people rate their own skill too high. The more confident you feel, the more carefully it pays to check your record.

Check yourself

Quick quiz

4 questions. Instant feedback, nothing is saved.

1Tap the group that earned the least in Barber and Odean's study.

Tap the chart.

The households that traded most earned 11.4% a year, while the market returned 17.9%.
2How did the researchers explain the poor results of the most active traders?

Barber and Odean argue that overconfidence explains both the high trading levels and the resulting poor performance.
3In 'Boys will be boys', how much more did men trade than women?

Men traded 45% more and earned risk-adjusted net returns 1.4 percentage points a year lower than women.
4Which habit counters overconfidence best?

A benchmark after costs shows whether your activity adds anything. Counting wins alone hides the losses.

of 4 correct.

Sources

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