- Overcoming overconfidence
Posted on 25th August 2006
by Chetan ParikhAdults stage frequent displays of overconfidence, and investing is fertile ground. People are prone to confuse accidental success with investment know-how. "Everybody's a genius in a bull market," goes an old saying on Wall Street. When stock prices are rising, many investors get swept up in an exhilarating sense of omnipotence. Conversations turn to how much money they've made in the market-even if it's only on paper. Those who haven't shared in the new wealth often become envious and are given to investment risks they might otherwise avoid.
But when the stock market becomes a money machine, why not pull the handle? For good reason. When investing seems a sure thing and novice players are convinced that they can beat experienced veterans, the risk of a fall is actually greatest.
Overconfidence fosters this false sense of empowerment. We tend to revel in our successes and forget the failures.
Just to break even on these trades, a replacement stock has to perform strongly enough to cover trading costs. But Odean found that the stocks investors bought actually fared worse over the following year. On average, the new stock underperformed the old one by 2.3 percentage points. Once trading costs are factored in, this shortfall more than doubles. By their reasoning, investors might think they're getting rid of losers and replacing them with winners. But in fact, they're doing just the opposite, as Thaler observes:
People exaggerate their own skins. They are optimistic about their prospects and overconfident about their guesses, including which managers to pick. If you ask people a question like "How do you rate your ability to get al0ng with people?" ninety percent think they're above average. 90 percent of all investors also think they're above average at picking money managers, which is why they think they can find the one-third who can beat the index, and why they're willing to pay money to get that chance.
Overconfidence is particularly acute in the independent minded world of online investing, where investors can tap into great quantities of information and buy or sell with just one click. But information is not knowledge. Odean studied the investment habits of 1,607 people who switched to Internet-based trading from telephone-based trading between 1991 and 1996. Before making the change, these investors outperformed the market by 2.4 percentage points on average. After going online, they traded more speculatively and less profitably-underperforming the market by 3.5 percentage points a year.
Investors would be better off to own the stocks of quality companies and hold them, instead of trying to sample everything in the store. As Pogo Possum, the classic comic strip character, might have noted wryly about active stock traders: "We have met the enemy and he is us." Trading is not investing. Many overconfident investors are convinced they have "hot hands," in the way a basketball player on a shooting streak will keep racking up points.
I think this is an extremely interesting issue.
This reminded me of an interesting posting in the Wallstraits froum: Do not buy on the way down
- The reason most investors/traders fail to make money in the market consistently is because of their mindset. People in general have a tendency to want to be right but of all endeavours, wanting to be right in the marketplace is a very costly exercise.
( Mindset issue! Do you all agree? Me think so woh! )
For most professions, being right is a clear necessity for the job especially those in the medical profession. Do anything wrong and you risk a patient dying on you. Thus this concept or need to be right is strongly ingrained in our mental psyche since we were young.
Now recall my other thread "Value Investing and Value Destructing"? The key problem I highlighted is that the average value investor aspires to be Warren Buffett. But there is only one Warren Buffett. As such, the average aspiring value investor is bound to fail in this very difficult task of figuring out the intrinsic value of a company. So what does this all mean? Does it mean then that it is hopeless of that the average investor will ever make money consistently in the market?
( Again let me say this... too often I have witnessed market players cannot accept the fact that perhaps they have made the mistake themselves. Simply put, 'they blame the 'machine', instead of acknowledging that perhaps it was the user that was wrong! )
Well, one of the most ironic things about the market is that you do not even need to be smart to make money. Because if one invests/trades with the trend of the market, one already has the odds on his side. Needing to be right and insisting that the market must perforce agree with you is the leading cause of poor investment performance.
( Hmmm... I do agree with that statement! )
Many value investors proclaim that it is impossible to tell when a bull or bear market or uptrend or downtrend is in force. Yet, all that is needed is common sense since when prices fall day after day, it does not take a genius to figure that the trend is down. On the other hand, if prices rise more often than they fall, does it take a genius to tell that an uptrend is underway?
Listen closely to the message of the markets instead of trying to predict the trend of the market. Let the markets tell you when to buy and when to sell. But this means that you surrender your intellect to the collective wisdom of the market. And this is of course hard to take for many egoistic human beings. Your thinking is often more irrelevant than you think.
- Well, one of the most ironic things about the market is that you do not even need to be smart to make money. Because if one invests/trades with the trend of the market, one already has the odds on his side. Needing to be right and insisting that the market must perforce agree with you is the leading cause of poor investment performance.
Which reminded me of this one saying from Warren Buffett..
It's optimism that is the enemy of the rational buyer. None of this means, however, that a business or a stock is an intelligent purchase because it is unpopular; a contrarian approach is just as foolish as follow the crowd strategy. What's required is thinking rather than polling.
Now this is where I find extremely interesting.
The very fine line between optimisim, confidence and the right reasoning.
Investor and traders know that the right reasoning is the very key to their success but being overconfident and not accepting the fact that perhaps we could be wrong in our own judgement could be extremely deadly.
Take a look at ourselves.
Well, who do we think we are???
Really!!
Who are we?
Are we all ever going to be the great Warren Buffett?
How?
We can try to be but let's be realistic, we will make mistakes along the way. Acknowledge this fact. Do not use the phrase 'it's ok because I am investing long term'.
This is because the greatest danger is if your initial stock selection is flawed, it is wrong.
And holding it long term is HOPING the market corrects your stock selection mistake. Remember mistakes costs us money!
So acknowledging we can be wrong is one extremely important issue.
Don't you think so?
I do think so.
***** This posting is dedicated to Unker Cili. *******
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