How should a trader deal with overconfidence? Maybe a better question about confidence--trading and otherwise--is not why people are overconfident to begin with, but why they stay overconfident. You see, the problem with overconfidence is not the innate bias toward optimism that most people seem to possess. Thats a good thing it keeps the world moving forward.

The problem is the inability to temper optimism as a result of prior experience. The truth is, we dont learn well enough from our mistakes. Consider this: If overconfidence is as big a problem as some say it is, it should be a short-term problem at worst. The learning process would ideally go something like this: We think highly of ourselves, the world and events show us who the boss really is, and we become less confident and more realistic about our knowledge and skills. Yet usually, this does not happen. Why? It seems to me that what we face as traders is that we fail to mix confidence with caution. It is when we are on a hot winning streak that we begin to think of ourselves and our trading as invincible. I cant count the number of times I have seen traders make a few nice sized wins and then watched them drift into a state of euphoria thinking to themselves: At last, Ive found the way to trade. They actually become giddy. They are so happy with themselves. But as the book of Proverbs so clearly states: Pride goes before a fall. Overconfidence leads to pride, even as far as arrogance. It is then when a trader must rein himself in and put up the wall of caution. When you are overconfident, you are ripe for a major setback in the market.

Joe Ross

Trading Educators Inc