Tuesday, February 1, 2011

Overconfidence

Under the paradigm of traditional financial economics, decision makers are considered to be rational and utility maximizing. The assumption of rational expectations is simply an assumption - an assumption that could turn out not to be true.

Behavioural Finance has the potential to be a valuable supplement to the traditional financial theories in making investment decisions. For the past few weeks I have introduced several behavioural finance concepts including: Availability Bias, Representative Bias, Anchoring Bias, Mental Accounting and Framing Effect. Next, I’m going to tallk about “Overconfidence”.

Overconfidence is a very common behaviour whereby investors tend to think that they know more than they actually do. They often overestimate their predictive skills and believe they can time the market. One classic example is listening to rumours. Investors who make investment decisions based on listening to hearsay rumours tend to be overconfident about the situation. Personally, I know a lady who listen to rumours got lucky the first time, she invested RM100,000 in a particular stock based on rumours from her fund manager friend. Her RM100,000 later became RM300,000. The next time she became greedy and invested RM300,000 into another stock recommended by the same fund manager, however, there was bad news regarding the company’s product and her RM300,000 became RM100,000.

Hence, being overconfidence may bring us good fortune at times, but it may also cause losses in our portfolio. To overcome this mental bias we need to follow our investment plan, practice diversification and always remind ourselves not to fall prey to those mental biases.

Finally, wishing all a Happy Chinese New Year! May the year of Rabbit be a prosperous one for all stock investors.


Happy investing,
Pauline Yong

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