How positive bias can lead overconfident investors to inflate the size of their wins and forget their losses
Overconfident investors, those more likely to trade more often and who had the greatest self-belief in their investment skills, were actually the individuals with the largest memory bias
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Overconfidence can be bad for markets and bad for investors. You just need to look at the recent crash in cryptocurrencies to see what can happen when investors believe they simply can’t lose. It’s certainly not a new phenomenon in the world of investing. From Tulip Mania in 17th-century Holland, to the dot-com bubble of the late 1990s, history is littered with examples of investor bravado leading them blindly into big losses when their sure-fire bet goes south.
Such extreme examples are not the norm, but they do demonstrate a common trait found in many investors; namely an overconfidence in their ability to beat the market.
Yet the reality is that overconfident investors don’t really make for good investors. They tend to trade more frequently despite losing money doing so, over-react to market signals and suffer from the “winner’s curse” in which they purchase overpriced investments. They are also more likely to commit investment errors such as under-diversification and overconcentration on familiar stocks.
While much has been written about the dangers of such overconfidence when it comes to the financial markets, there has been less time spent discussing why it is such a common characteristic among investors. This anomaly seems especially strange when you consider how easy it is to double check past success with a quick scan of your financial statements.
[This article is republished courtesy of INSEAD Knowledge, the portal to the latest business insights and views of The Business School of the World. Copyright INSEAD 2024]