CFA Level IPortfolio ManagementMedium
An investor who outperformed the market for two consecutive years begins trading more frequently, taking larger positions, and using greater leverage, believing his stock-picking skill has improved based on his recent winning streak. This behavior is best described as an example of:
- ARepresentativeness bias
- BLoss aversion bias
- COverconfidence bias
- DRegret aversion bias
Show answer & explanationAnswer & explanation
Correct answer: C. Overconfidence bias
Overconfidence bias occurs when investors overestimate their own knowledge or ability, often after a run of good performance, leading to excessive trading and risk-taking. This differs from loss aversion (feeling losses more than gains) and regret aversion (avoiding decisions that could lead to regret).
Why the other options are wrong
- A. Representativeness involves categorizing new information based on past patterns, not skill overestimation.
- B. Loss aversion relates to asymmetric sensitivity to losses versus gains, not overestimating skill.
- D. Regret aversion involves avoiding actions for fear of future regret, not increasing risk-taking.
Overconfidence Bias
An emotional bias in which investors overestimate their own abilities or the precision of their information, often leading to excessive trading and underestimation of risk.
- Often follows a string of successful outcomes
- Leads to underdiversification and excessive trading
- Distinct from self-attribution bias, which attributes success to skill and failure to luck
Memory trick: Two good years, ten bad trades — confidence outran competence.