Don’t Confuse Brains with a Bull Market
May 19th, 2006 | By Penny Sleuth Contributor | Category: Investing Strategies“Dude, check this out, I made $560,000 in the stock market in the late 90s,” said a young man at a bar last night. He had overheard my conversation with a friend about investing and came up to me to say how much money he’d made from the stock market.
Even before I could congratulate him on his success, he added, “Dude, I lost all of it in the market crash. I’m stupid man, plain stupid. I got too overconfident, man.” Clearly he’s still remorseful for his overconfidence and losses from six years ago.
That’s what the stock market does to you if you don’t understand how psychology affects investments. Overconfidence causes people to overestimate their knowledge, underestimate risks and exaggerate their ability to control events.
Dr. John Nofsinger is a finance professor and psychology expert. He is also the author of Investment Madness. How Psychology Affects Your Investing…and What To Do About It. In his book, Nofsinger says, “Security selection is a difficult task. It is precisely this type of task at which people exhibit the greatest overconfidence.”
“We begin the process when we enter a new activity, say, investing. We do not know our ability at investing, so we observe the consequences of our investment decisions. If we are successful, it is human nature to attribute that success to our ability. But not all success comes from high ability. Indeed, some successes come from dumb luck.” So, unlike many psychological biases, overconfidence is learned.
Take, Wall Street Journal’s Dartboard column. Periodically, the Journal invited four or five investment analysts to pick a stock for purchase. Simultaneously, they pick four or five other stocks by throwing darts at the financial pages.
They follow the analyst’s stocks and the dartboard stocks and report the returns produced from both. Nofsinger says, “More likely than not, the dartboard portfolio beats the pros. Does the dartboard thrower have superior stock-picking ability? No, it’s just that dumb luck success is common.
Even Nobel Prize-winning economists have committed the mistake of over confidence. Take the hedge fund Long Term Capital Management for example. The fund was started by two Nobel prize winning economists, Myron Scholes and Robert Merton. It employed 24 PhDs.
The fund began in 1994 and had fabulous profits. The fund had $4 billion in equity but it also had $100 billion in leverage. In 1998 the fund found it difficult to find the sort of arbitrage opportunities it had been using in the bond market. So the fund made riskier and riskier trades.
Around the same time, Russia defaulted on its debt, casuing a chain of events to happen that would eventually crush the fund. Bond markets all over the world crashed and investors fled to safer investments. As a result, Long Term Capital Management’s equity was sliced from $4 billion t0 $0.6 billion in just one month.
“How could a hedge fund with such brainpower lose 90% of its equity in one month?” asks Nofsinger. “Apparently, in designing their models, the fund’s masterminds did not think that so many things could go wrong at the same time. Doesn’t that sound like their range of possible outcomes was too narrow?”
What can you do to avoid the same mistakes of overconfidence that caused even Nobel Prize-winning economists to lose in the investing game? Nofsinger says controlling yourself and reducing desire are keys to stock market success. Here are some of his tips:
- Employees should contribute to their 401(k) plan and refrain from spending the money early through loan programs. To remember the importance of this strategy: Save much, don’t touch.
- To control emotional biases and trading behavior, investors: Buy low, sell high.
- To maintain a long-term perspective during bear markets: Stay the course.
- Retired people who don’t want to outlive their money control spending with: Don’t touch the principal.
Most importantly, understand WHY you are investing. “I want to make a lot of money” or “I want to retire soon” is not good enough. Define specific investment goals for yourself. And constantly review your own investment performance to see if your behavior matches your goals.
Regards,
Sala Kannan
May 19, 2006
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