OVERCONFIDENCE
This is the most powerful investor bias that affects inexperienced to experienced investors. Overconfident investors overestimate their knowledge (illusion of knowledge), underestimate the risk (illusion of low risk), and believe they can control events that they cannot (illusion of control).
Result - Overconfidence investors trade too much, take on more risk than the return, mistake information for knowledge and overall make poor investment decision.
Example - ENRON
Many Enron employees invested up to 100% of their retirement 401(k) in company stock. When the stock started dropping, they continued to hold Enron stock and did not sell. Granted that Enron executives were lying and hiding losses, and rules in 401(k) programs did not allow them to sell all their stock, but employees still held on to shares they could sell all the way to the bottom.
Why did they make this mistake?
Illusion of knowledge - Because they worked for the company, they believed they knew more than the average investor, when in fact, they knew very little about the company they were working for. They may have had more information about Enron, but not more knowledge. Only top management had the knowledge about the company.
Illusion of Control - Because the Enron employees were actively involved with the company and their 401(k) choices, had more information about Enron, and had seen their stock price go up and up, the Enron employees believed that they were "in-control" of their 401(k). They previously doubled or tripled their 401(k) money in Enron stock, so they must have made a smart decision in buying all Enron stock and felt "in control."
Why did they not sell when the stock dropped...more in Regret
Illusion of low risk - Is putting all your retirement eggs in one basket risky? Enron employees would have said No. "Why would it be risky? I know the company. The stock has tripled. I would know if there was a problem at the company. I can move my money anytime, if the stock drops." Every financial adviser will tell you to diversify your investments to reduce risk, but the Enron employees did not believe there was any risk in having all Enron stock and after the price drop, they believed that the price will come back.
Example - Trading Too Much
Overconfident investors have at least 85% annual turnover of their portfolios. In a study by Brad Barber and Terrance Odean of 38,000 household, they found that single men and married men trade 20-30% more than single women and married women. Psychology indicates that men are normally more overconfident than women in "manly" tasks, such as financial management or betting.
Just as in the Enron example, the reasons for this overconfidence comes from believing they know more information or know more precise information than their peers (illusion of knowledge), believing they have influence on the stock because they chose the stock, have a lot of information, and have made good decisions in the past (illusion of control).
You might say, "So What? If these men had great returns, then who cares how many times they turned over their portfolio." Ah, the study by Barber and Odean also looked at gross and net returns (returns minus commissions) of the households by dividing the households into 5 groups.
The average gross return for high and low turnover groups was 18.7%, so high turnover did not equate to higher gross returns. Now, if you add in the commission costs for the trades, the highest turnover group had net returns 7% lower than the low turnover group.
Tips
1. Do not put all your eggs in one basket. If you work for a company with public stock, diversify your 401(k) holding as much as you can within the rules of the plan. Sell stock they match as soon as you can. You work for the company, so your salary is tied to the company already. Do you want your retirement tied to the same company. Would you bet your whole salary and retirement on one racehorse? The same goes for putting all your money in one stock. Diversify your portfolio to at least 12 or more different stocks or better yet, get a ETF or mutual fund.
2. Do not mistake information for knowledge. Because you can get so much information from the internet and possibly inside sources in your company, it is easy to believe you know more than the average investor. However, unless you are a full time investment analyst or the CEO, you really don't have all the customer, competitive, operational, financial, and global market knowledge needed to make a rational decision. Diversify to hedge your bets.
3. Find good stocks, mutual funds and ETF to buy and hold for the long term. Commission costs or expense fees on mutual funds and ETFs can eat into your returns. More trading = more costs. Remember the old adage, "The best way to make money is not spend money." This is true for investing too. If there were 2 ETFs that tracked the Dow Jones and one of them had annual expenses of 0.50% while the other one had annual expenses of 0.2%, which one would you pick? Always add commissions and fees into your returns calculations, so you can make a rational decision.
