Overconfidence leads to over-trading, but are we right to think we're better than our peers?
Are you a better than average driver? Surveys show that most people think they are. But when you think about it, by definition only half of us are above average, so clearly there are some delusional drivers out there. You may even have met some.
How about investing? If you're picking stocks, are you smarter than the average stock-picker? If you don't believe you are, then you have no business picking stocks -- if you don't think you'll beat the market, then surely you should just buy the market, i.e. tracker funds. Even below-average drivers may still have to drive, but only equity fund managers are obliged to buy shares.
But in the nature of things, the average stock-picker turns in an average performance, clearly scoring lower than he thought he would.
One of the results of this overconfidence is over-trading. Even when we sell, we may have lost confidence in a specific share or in the stock market, but we are still confident enough in ourselves to believe the we should meddle with our portfolios rather than leaving them alone.
Some interesting tactics to counter this tendency are discussed here and here, but let me add another: tracking your sales. When buying a share, many of us note the value of the FTSE 100 (or some other index) to see if we out-perform it -- you can set up these portfolios very easily in Yahoo Finance, for example. But how many of us do the same when we sell a share? Surely it's just as relevant to know if we were right to sell?
And if you're churning your portfolio -- selling one share to buy another -- it's easy to watch the performance of each share side-by-side to see if you made the right decision. This can be a humbling experience.
Of course there's a limit to how nerdy one should be about all this, and there's also a limit to its usefulness:
- It could be argued that the performance of a sold share becomes less relevant over time, as you follow it less closely.
- You could still have made the 'right' decision to sell a share that subsequently outperformed if it became too risky for you -- it may have gone from uncomfortably overvalued to ludicrously overvalued.
- Remember, too, that unless you're a very active trader, you're probably dealing with a small sample size and the results of your trading may be due to chance.
But even allowing for all those caveats, if you think you're better than the market I believe you should test that assumption with hard data.
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