Over Confidence
Forecasting errors often begin with an over confidence in our own abilities, experiences, and what we qualify as knowledge. And of all the mental errors, overconfidence is perhaps the most deadly. We are just sure we can pick a bottom, catch a falling knife, or just know that Company ABC is the next great winner.
And sometimes it is, but then, if we were to take a room of 5,000 people, have each flip a coin 5 times in a row, we're going to have 'winners' who can hit heads every time. In fact I should have approximately (5,000)(.5)^(5) or ...a lot! The result is that we may be chasing ghosts/coin tosses that represent little more than a random walk through a lot of noise and events.
Similarly, studies of physicians and how well they predict their score on upcoming medical exams, drivers in Sweden of which the majority believe they are better than average, and how we score out our 'looks' all hold the same key element -- we are too confident. My favorite is to ask a room of people to write down on a scale of 1-10 how attractive they are. Psst -- the average score is 7!
Overconfidence is also a major factor in trading too frequently for the retail investor. Round trip (a buy & sell) trading costs that include broker fees and the bid/ask spread are expensive but only part of the problem. Even more importantly is the temptation to time the market, and may result in missing out on big moves.
We also tend to rely too much on our familiarity with one or more companies only to find out that its a great company, but a poor choice for an investment. We've worked at Company ABC for years, and it really is a good company to work for, but maybe not so much to overload in our portfolio.
