At Quantum Mutual Fund, we follow a disciplined research and investment process while evaluating stocks. We choose stocks based on risk and return. This reduces the impact of emotions or psychological biases.
Individual judgments are also minimised by adopting a team approach to investing. We do not rely on 'star' fund managers. Overconfidence is one such bias which can impact your investment returns and performance. To know more about this, read on. . .
A rising tide raises all boats. Similarly, a rising stock market also increases the confidence of investors. The increased returns impact the psychology of investors.
- Overconfidence can be easily mistaken for good skill and talent.
- Overconfident investors suffer from the following:
- They get illusions of control; they assume that they can direct the outcome of the stocks they hold.
- They delude themselves that the stocks they own will perform better than the stocks they do not own.
- Overconfidence causes people to overestimate the accuracy of their information.
- They tend to cling on to their predictions and expectations about their holdings, despite evidence to the contrary.
During the period from 1991-1992, virtually no investor believed that the stock market would correct downwards. Similarly, during the tech stock build-up from 1998-2000, investors believed that prices of technology stocks would continue to rise exponentially.
Investors believed that they had the ability to predict technology trends and therefore the movement of technology stocks.
Hands-on experience can also cause overconfidence. In the United States, during the late 1990s, online brokerages took off in a big way, aided by a bull market. As larger numbers of investors tracked their portfolios almost daily, they found that the performance was quite promising. In the face of this evidence, they couldn't be faulted for thinking that they were better than their investment advisors at picking stocks.
Despite their 'prowess,' the tech bubble collapsed and eroded huge amounts of investor wealth. The recent surge in retail participation in the Indian capital markets through online brokers seems to be a repeat of the phenomenon.
News, hot tips and preconceived notions may trigger overconfidence. For instance:
- Having read the headlines about GDP growth, an investor may become confident that the trend will continue. He may overlook factors that indicate GDP growth could slow down.
- The overconfident investor may also base his investment decisions on certain strongly held beliefs like:
- I will only buy stocks that are below Rs 10. (Assumption: Lower priced stocks stand a greater chance of appreciation).
- I will only buy stocks that have fallen by 20 per cent in the past three months. (Assumption: What goes down should come up).
Overconfidence can lead to:
- Excessive trading: Studies* conducted in various markets indicate that trading volumes increase during and immediately after a bull market. Higher returns in the past encourage investors to trade more in the anticipation of greater profits.
- Higher trading volumes, resulting in increased transaction costs and, thus, an increase in the investor's tax liability.
- The investors may focus only on a few stocks or sectors leading to a less diversified portfolio.
- Winning stocks may be sold too early and losers could be held for too long.
- An above-average performance in one stock or sector may lead to the belief that the entire portfolio is doing well, which may not be true.
At the end of the day, one invests to earn returns. Emotions and feelings have to be reined in and an objective approach has to be adopted.
* Statman, Thorley and Vorkink used US market level data to test the hypothesis that overconfidence leads to higher trading volume.
Source: The Psychology of Investing by John R. Nofsinger and the author's experience.
The author is Director, Quantum AMC. Email: Subbu@QuantumAMC.com
Disclaimer: Investment in mutual funds are subject to market risks including uncertainty of dividend distribution and the NAV of the scheme may go up or down depending upon the factors and forces affecting the securities markets. Please read the offer document of any scheme/s before making any investments.
