HOW TO BEAT YOUR BIASES
Benjamin Graham once said that the investor’s main problem and his worst enemy- is likely to be himself. Behavioral finance is best known for the list of various cognitive and emotional investor biases that researchers identified and the evident effects they have on investment decision-making.
Overconfidence is the most significant and most damaging cognitive biases. It is built so deeply into the structure that you couldn’t change it without changing many other things. In this article, we will be explaining what it is and how to circumvent it. So, let’s dig deep into the relation between overconfidence and cognitive abilities.
In basic form, overconfidence simply is the unwarranted faith in one’s intuitive reasoning, cognitive abilities, and judgments. For example, it is always advised not to drive while you are drunk. In spite of knowing this thing, drivers continue to get behind the wheels after they have had too much to drink and if you suggest to them that they shouldn’t drink while driving, the typical responses are always “I am ok” or “I can handle it”. These all are the overconfident abilities to drive under the influence and they actually believe they can beat the safety odds better than everyone else.
Similarly, investors who exhibit the overconfidence bias, overestimate their abilities which could result in disastrous consequences. Investors simply buy stocks without doing any research or they try to guess the direction of the market without realizing the market’s current direction, also the market’s direction from day to day isn’t predictable.
How to combat it?
So how to overcome this overconfidence in investing in stocks? The most important thing an investor could do is to establish a “mad money” account. This account involves the individual taking a small portion of their money just for “overconfident” trading activities while leaving the other reminder of their money to be managed in a disciplined way. This somehow maintains a balance between safe and risky approaches. This will allow the investors to trade their accounts, while at the same time maintaining the majority of money in an efficient way.
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The overconfidence effect is a well-authorized bias in which people’s own subjective confidence in his or her judgments is always greater than the objective accuracy of those judgments, especially when the confidence is really high. So, overconfidence is one of the risky approaches when it comes to trading and investing your money in the stock market.