Overconfidence in the Trading Activity Context

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Table of Contents

Introduction
Decision-Making in Trading Activity
Conclusion
References

Introduction

Almost every adult person needs to make financial decisions every day and sometimes even more than once a day. The scale of such decisions may vary according to the influence of the decision on a person’s life and emotional involvement. Financial trading is now accessible for many people lacking professional training and analytical skills, so many internal and external components affect their financial behavior, such as age, gender, mentality, cultural attitude, and other social. Lack of rational analysis or emotional acting leads to higher-risk transactions and more frequent and rushed trading. Due to human nature, it is tough to make choices or pass judgments without any emotional involvement. Still, overconfidence may be far more damaging to financial processes than other sentiments and cognitive biases.

Decision-Making in Trading Activity

Financial Decision Making

Financial behaviors have many strong connections to feelings and instincts. Ideal economical operations on an industrial scale should involve the smallest amount of human factors possible, which is impossible to recreate in daily financial interactions. For the world economy to function, many individuals need to make personal choices regarding operating money and other resources. Due to those mentioned above, it is essential to acknowledge and be aware of one’s mental state during financial planning and acting. Perception of facts through the veil of sentiments distorts analyzed data. The negative feelings of sadness or disappointment push people to make unsound decisions and splurge (Greenberg & Hershfield, 2018). On the other hand, a state of positive excitement sometimes leads to unrealistically encouraging assessment and over-optimistic planning. Some institutions and businesses use this to predict consumer economic actions to appeal to their core instincts to get a favorable human reaction. While every emotion is temporary, the result of an irrational financial action may irreparably damage one’s economic well-being. There is no need to eradicate unconscious influence in everyday economic activities, but in long-term planning and for life-affecting decisions acquiring cognitive perspective may be crucial.

Another factor that can make a negative impact on decision-making is a peer-pressure. Society presents rough guidelines and requirements with a distorted and polished vision of success. Consumers acquire debt and unhealthy trading behaviors driven by the need to fulfill the requirements. The phenomenon appears because of the basic human instinctive desire to fit in and be a part of a group (Hinvest et al., 2022). Pressure and expectations of society might lead an individual to consciously take financially disadvantageous and irrational actions to fit the pattern. In this case, an open-minded and unbiased evaluation of one’s needs and perspectives helps create solid financial strategies.

Psychological Explanation for Trading Activities

Financial markets primarily act on the principles of basic human behaviors, but the accessibility of trading to the general population brings influences cultural attitudes and socially driven behaviors. Some emotions make people more involved in trading, but others can lead to dangerous consequences. Venturesome activities, like stock trading, appeal to the human psyche similarly to gambling (Greenberg & Hershfield, 2018). While trading, people are thrilled and anxious about the risk, greedy for easy money, and therefore their perception is emotionally clouded.

Popularizing the stock trade brought people of different groups and classes to the financial markets. Members of different age groups usually act differently due to a lack of negative experiences among younger consumers and a lack of expectations among older ones (Eberhardt et al., 2019). Consumers from specific ethnic groups and countries also show notable financial behavior patterns. Greenberg & Hershfield (2018) stated that every country’s financial market usually demonstrates standard cognitive patterns and behaviors traditional to the local mentality. Some people even bring superstition into trading, avoiding closing deals or making financial operations on specific dates. To conclude, every consumer’s cultural and social background affects proceedings and tendencies in financial markets.

People’s temporal perception and impatience also explicitly influence economic activities. Extensive research demonstrates that a small gain but sooner is primarily preferable for members of financial markets than a more considerable amount but further in time. However, there is opposite information in the case of losses: people tend to choose to lose more significant amounts later than smaller amounts in the nearest future (Hinvest et al., 2022). Those facts explain rushed and unbalanced financial decisions in time-limited offers.

There may be many biases involved, except being overly confident during trading activities. Another side of self-assurance is insufficient confidence, which makes traders overestimate financial risks and lose possibilities (Nur Aini & Lutfi, 2019). Strong belief in own knowledge may cause availability bias expressed in ignoring unavailable information and limiting prospects. Overly skeptical perception is also a way to lose potential gain by locking on negative experiences and believing that nothing good can come with a small investment. An unbiased approach is an inseparable part of profitable trading operations.

Methodological and Empirical Controversies

Among existing cognitive biases, overconfidence is one of the most harmful ones. Combrink & Lew (2019) stated that accurate self-rating and assessment of one’s abilities are hard for people and even more challenging when they need to be compared to others. The feeling of unrealistic power and overestimating one’s skill and knowledge may lead to horrendous mistakes. Overconfident people are prone to getting into dangerous situations due to a lack of preparation and misjudgment of their possibilities. Overprecision, overestimation, and over placement are distinguished parts of this complex concept.

Therefore, overconfidence-biased financial decisions can lead to the destruction of individuals’ or corporate economic well-being. Nur Aini & Lutfi (2019) stated that experiments show that presumptuous investors’ amounts of transactions usually go over safe levels, and their returns are mostly lower than expected. Surveys show that experienced investors rate their performance close to the 80^th percentile, but at the same time, they do not compare themselves to their colleagues (Combrink & Lew, 2019). The level of self-confidence grows with professional experience and expertise, but not always proportionally.

Evidence on the Relationship between Overconfidence and Trading Activities

Overconfident bias can attack the result of trading activities in three main types, laid after that in no specific order. First, overprecision can be explained as irrevocable irrational and undoubting belief in own knowledge of future events. Studies show that overprecision specifically leads gamblers and stock investors to higher-risk decisions (Nur Aini & Lutfi, 2019). As described by Bernoster et al. (2019), it is essential to differentiate between overprecision and optimism. Even though both can stimulate and drive trading activities, empirical and theoretical studies state that the two phenomena should not be blended.

The second type of overconfidence is an overestimation, which expresses itself in an individual as an over-evaluation of own capabilities. People who experience overestimation bias cannot accurately access the relevance of their expertise in specific situations. Such behavior might make a person get over the borders of their comfort zone and result in self-growth. Still, in trading activities, it results only in hasty unlucrative financial choices most times (Cheng et al., 2021). Overestimation may prevent an investor from looking for additional information and fact due to assurance that their knowledge is already more than enough.

The third type of overconfidence shows itself as the strong confidence of an individual in their excellence over a significant population or group of people. The name of this belief is over placement, and people who stick with it are usually very aggressive and forceful with their advice and opinions because they (in most cases) wrongfully put their abilities over others’ (Combrink & Lew, 2019). The danger of this type of overconfidence is that an incompetent but overconfident individual may persuade other people into damaging financial actions. Absolute confidence in thoughts and opinions makes their deliverance more persuasive to others.

Conclusion

Cognitive biases or feelings very often taint the financial decisions of non-professionals. Emotional involvement is not critical for day-to-day economic choices but may be destructive to the general financial well-being of an individual or a corporation. To gain success in trading activity, a person might try to overrule initial sentimental responses and take actions based on cold calculation. Despite the challenges of estimation and evaluation of overconfidence bias, studies show a correlation between unreasonable self-assessment and high-risk financial choices. Every type of overconfidence has its distinctive manifestations and signs. It is vital to see the difference between an optimistic approach and an overconfidence bias. Even though sometimes high-risk decisions due to overestimating one’s knowledge and abilities may result in significant gains, research shows that overconfident consumers and investors mostly experience negative tendencies in trading activities.

References

Bernoster, I., Rietveld, C.A., Thurik, A.R., Torrès, O. (2019). Overconfidence, optimism, and entrepreneurship. Sustainability, 10(7):2233.

Cheng, J. T., Anderson, C., Tenney, E. R., Brion, S., Moore, D. A., & Logg, J. M. (2021). The social transmission of overconfidence. Journal of Experimental Psychology: General, 150(1), 157–186.

Combrink, S., & Lew, C. (2019). Potential underdog bias, overconfidence and risk propensity in investor decision-making behavior. Journal of Behavioral Finance, 21(4), 337-351.

Eberhardt, W., Bruine de Bruin, W., Strough, J.N. (2019). Age differences in financial decision making: The benefits of more experience and less negative emotions. Journal of Behavioral Decision Making, 32(1) 79– 93.

Greenberg, A. E., & Hershfield, H. E. (2018). Financial decision making.Consumer Psychology Review, 2(1), 17–29.

Hinvest, N., Fairchild, R., & Ackert, L. F. (Eds.). (2022). Emotions and cognition in financial decision-making. Frontiers Media SA.

Nur Aini, N. S., & Lutfi, L. (2019). The influence of risk perception, risk tolerance, overconfidence, and loss aversion towards investment decision-making. Journal of Economics, Business & Accountancy Ventura, 21(3), 401.

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