Malicious ego: How overconfidence hinders investors

Financial markets are living in perfect storm mode this year. The war in Iran, spikes in energy prices - volatility has become a constant backdrop. Now even low-yielding assets can no longer be considered safe. In such a situation, you would like to believe that you at least fix profits in time, "sit out" drawdowns and generally do not lose your money. But there is a threat that comes from the investor himself - overconfidence in his abilities and skills. How does this work, and how can an investor protect himself from his ego?

Every person has cognitive distortions. These are systematic errors, "bugs" in thinking, which, when activated, make a person misinterpret information and make irrational decisions. Among such "brain traps" is the so-called disposition effect. This is a tendency to sell assets that have already made a profit and to hold those that have gone negative for too long.

An experimental study called Disposed to Be Overconfident, conducted by a team of scientists from Bocconi University (Milan) and the Haas School of Business at the University of California, Berkeley, has shown: this effect, in conjunction with inflated self-confidence, creates a mental vicious circle. "Capture the gains, weather the losses" literally teaches the investor to further overestimate his or her abilities.

It's pure psychology: it's easier for us to record a small victory than to admit our loss.

That is, if an asset goes up in price by 10-15%, the investor's hand unconsciously reaches out to lock in a profit: "It is better to take the money now than to regret it later. If another instrument becomes cheaper by 20-30%, the hope is turned on: "Just a little bit more, and everything will return to my entry price".

As a result, in the history of transactions the investor has a lot of closed "small victories" and no less open, but not yet recognized defeats.

A separate study by Terrance O'Dean of the Haas School of Business showed that sold "winners" continued to outperform the market by an average of 3.4 p.p. in the year after the investor sold them. In contrast, losing assets left in the portfolio were yielding below the market and dragging the portfolio down.

In the original study, the authors also assessed through an experiment which way people tend to capture gains and losses and how method preference changes our self-image as an investor.

Participants were given a portfolio of stocks and offered several rounds of trading under simulated conditions. The first group - "sellers on the rise" - was obliged to discount stocks that turned out to be on the upside and could keep the losing ones. The second group - "those selling on the fall" - on the contrary, was obliged to sell unprofitable securities, and could keep the growing ones if they wanted to.

After a series of trading rounds, all participants were asked how confident they were that they could beat the other group in the next round, and how they themselves subjectively rated their specific asset selection and portfolio management skills.

It turned out that participants from the "selling on growth" group, which systematically realized wins and kept falling assets in the portfolio, had a significantly higher assessment of their trading ability compared to those who were forced to lock in losses.

Unrealized losses are reflected weaker in the "psychological accounting": the less the investor admitted defeat and the more profitable deals he had closed, the more "successful" he felt.

However, the mathematical result for the portfolios of both groups did not provide a basis for this difference in self-assessment.

"People judge their investment abilities by realized gains and losses, not total portfolio returns," the study's authors point out.

In terms of behavioral finance, the link between the disposition effect and overconfidence can be represented as follows: tendency to hold loss-making assets for too long and hastily sell growing ones → distorted sampling of one's own successes → overconfidence → unnecessary risk in the future.

Normally, confidence simply pushes us to trade actively. In the current realities of high uncertainty and volatility, it shifts our internal trading statistics: the higher the volatility, the more often "quick" profits and losses appear. This gives the investor more reasons to close a plus and "sit out" a minus - from small wins, the investor's confidence grows regardless of how well he or she actually manages risk.

This also leads to the fact that the more confident an investor feels, the easier it is for him to make more "drastic moves". As a result, the portfolio becomes both more fragile and more "nervous".

A study by a group of scientists also shows that even an artificially set sales pattern changes an investor's self-esteem. Imagine what the effect could be when trading in the real market when you set this pattern for yourself.

The disposition effect and overconfidence are not in themselves a defect and often not even a personality trait, but rather a "bug" of our souls and brains. But their influence can be reduced in several ways:

- Look at the portfolio as a whole, in the aggregate, and not only at the history of closed deals. For example, at least once a month evaluate the result for the entire portfolio: for each position, taking into account unrealized gains and losses. This is trivial, but it reduces the increased attractiveness of small closed wins.

- Formulate exit criteria in advance, both in terms of profit and loss. Studies of trader behavior show that having a pre-determined plan reduces the power of the disposition effect and emotional decisions.

- Separate the evaluation of your skills from your short-term results. In fact, the original research says, "A few good trades in a row amid unrecognized losses doesn't mean you've already become an investment guru." Evaluate your abilities over a long series of decisions and how you manage risk overall, not the last few good trades.

- Consciously recognize losses as an inevitable part of investing rather than a personal failure. This is called cognitive reassessment. This approach reduces the emotional reaction to the loss of profitability and weakens the hope for a "wait and see" approach. Moreover, volatility is not going anywhere - it is a constant companion of the market.

This article was AI-translated and verified by a human editor