Overconfidence in investors can be hazardous to their wealth. What is overconfidence? It is when people feel smarter than they actually are. This overconfidence can be of one’s knowledge or one’s ability.
What happens when overconfidence meets the market? Of course according to the classical economic theory no one is overconfident. In fact stock markets should not even exist if we look at the efficient market theory. Efficient markets assume that the price is right, then why should anyone want to trade. The volumes should be zero.
But as soon as overconfidence of investors start dominating volumes and turnover explodes in the market. Everyone thinks they know more than everyone else and they trade more.
Perhaps the most striking example of overconfidence amongst investors especially professionals, is their general belief that they can out smart everyone else- effectively get in before everyone else and get out before the herd goes for the exit.
We all know how hard it is to do that. This is what a large number of investors spend their time doing: trying to be the smartest person in town.
Remember the mother of all public issues ’Reliance Power Ltd.”. A Rs.10 stock was offered to the public at Rs.430, at a ridiculous high PE. There was a gray market premium of around Rs.400. It was a sort of a green field project but commanded a hefty premium.
Investors knew all the facts but they all were over confident that once they get the allotment they would sell off the stocks in the market before anyone else. However everyone one was thinking the same. On listing the herd came to sell and the prices crashed. Their were huge losses borne by these overconfident investors. This included not only the small retail investors but herds of professional investors too.
Even in current times there is no need to be excited by the quarterly results , the inflation and GDP growth estimates, the moves of our new RBI governor, the rupee recovery, the poll surveys, election results etc. Repeated information of such superficial knowledge can turn in to a strong belief and that in turn could make you prone to over confidence bias.
So if we cant outsmart everyone else, how can we invest and be successful in the investing profession? The conventional wisdom is that you really don’t need to outsmart any one. It is important to stick to our investment discipline and judiciously follow the process we have adopted. Ignore the actions of others and stop listening to the so called experts on you your favorite TV channel. Investment returns are a function of discipline and patience.
