Overconfidence is a common bias when an individual perceives that his abilities are higher than the ‘actual’ or realised abilities.

Overconfidence is a miscalibration of subjective probabilities.

I want to focus on one of the common manifestations of overconfidence in the financial field, the Overestimation of risk-tolerance. It’s one thing to fire up a spreadsheet and simulate losing a large chunk of assets, but quite another when it happens in real-time. A good analogy is how experiencing a plane crash in a simulator compares with the real thing.

Humorist and financial journalist Fred Schwed would say: “There are certain things that cannot be adequately explained to a virgin either by words or pictures. Nor can any description I might offer here even approximate what it feels like to lose a real chunk of money that you used to own.”

A suboptimal portfolio you can execute is better than an optimal one you can’t. Every person has his own unique ability to tolerate volatility on his own portfolio. And this threshold of tolerance can change along the way (owing disease, divorce, age, etc.).

We know from historical data that, over long periods, the stock-heavy a portfolio, the higher its returns will be. But the prime prerequisite for a successful portfolio is that it survives. And it should survive long enough for compound interest to work its magic. The best way of ensuring that is to have a portfolio that can be held through the inevitable episodes of economic and financial turmoil. And the holding ability is correlated with the risk-tolerance of the owner of the portfolio.

Mental accounting bias can comes in help for designing a portfolio, dividing it into two completely separate pools, the low volatile assets necessary to sustain body and soul and the high volatile assets aimed to compound wealth. This metal accounting strategy is commonly called the “two bucket” approach to asset allocation. Thus, you have a retirement bucket for your basic needs, and a dreaming bucket.

Charles Ellis observes that you can win the investment game in one of three ways

  1. by being smarter
  2. by working harder
  3. by being more emotionally disciplined than the other participants

I suggest you to focus on the point 3….that is the field of behavioral finance.