Handling Unexpected Success

Handling Unexpected Success and Controlling Overconfidence

You can't trade the markets unless you have self-confidence. Trading is a field where you'll see setback after setback, and the only way to pick yourself up quickly and fight back is to have rock solid confidence. But building genuine, unwavering confidence in your trading abilities takes time. It's necessary to experience a variety of market conditions and learn which trading strategies work best under which specific conditions. It's not something that happens in just a few months. Many trading experts say it takes several years of trading before you will gain enough trading experience to build a genuine sense of confidence. In the meantime, novice traders must find a balance between under- and overconfidence.

It's hard to distinguish genuine confidence from arrogant overconfidence, particularly if you are a novice trader. Novice traders must look out for times when their overconfidence makes them take unnecessary risks. For example, Brad Barber and Terrance Odean (2000) have shown that when novice online traders face an unexpected windfall, they tend to over-trade. One of the traders in our Innerworth Master Interview series said, "If you're overconfident, you fall into traps. When I have a string of ten days where I made money every day, I have to watch myself. I have to get more defensive after a string of good trading days because I am tempted to think that I'm invincible. In that mindset, I get stubborn and take bigger risks." Taking big, unnecessary risks can produce large losses. When you're first starting out as a trader, it's vital to stick to your risk limits, but many traders find it hard to avoid taking greater risks when things are going well.

In their book, "Why Smart People Make Big Money Mistakes," Gary Belsky and Thomas Gilovich (1999) aren't surprised by why people are overconfident. For them, the more interesting issue is why traders have trouble controlling their overconfidence. According to Belsky and Gilovich, "The problem is the inability to temper optimism as a result of prior experience. Frankly, we don't learn well enough from our mistakes."

IIndeed, many novice traders don't learn from their mistakes. They watch their account balance rise and fall with the ebb and flow of the markets. They don't pick and choose ideal, high probability setups and they trade in market conditions that are not conducive to their methods. They over leverage their trading knowledge and end up making costly mistakes. It's wise to take precautions, especially after an unexpected winning streak, where you are likely to feel euphoric because of an unanticipated windfall. Under such circumstances, you'll be prone to take risks because you believe that you are now merely risking the "house's money." But your winnings, no matter how you won them, are yours, and you should protect them.

The most obvious way to gain control over your overconfidence is to manage risk carefully, so a series of losing trades will not deplete your trading capital as rapidly. In addition, make sure that you trade with a well-defined trading plan. If you manage risk and follow a well-devised trading plan, you'll be able to minimize overconfidence. When you allow a trading plan to guide you, you'll trade more rationally and unemotionally. You'll focus on the plan, rather than impulsively allowing your feelings of invincibility to distract you. Overconfidence disrupts many novice traders. Don't let it control you. Manage risk and follow your trading plan. You'll stay grounded, unemotional, and profitable.