3. Overconfidence
Many successful people reject the possibility of luck or randomness having any effect on the outcome of an event, whether a career, an athletic contest, or investment. E. B. White, author of Charlotte’ s Web and a longtime columnist for The New Yorker, once wrote,“ Luck is not something you can mention in the presence of a self-made man.” According to Pew Research, Americans especially reject the idea that forces outside of one’ s control( luck) determine one’ s success. However, this hubris about being self-made can lead to overconfidence in one’ s decisions, carelessness, and assumption of unnecessary risks.
In October 2013, Tweeter Home Entertainment Group, a consumer electronics company that went bankrupt in 2007, had a stock price increase of more than 1,000 %. Share volume was so heavy that FINRA halted trading in the stock. According to CNBC, the reason behind the increase was confusion about Tweeter’ s stock symbol( TWTRQ) and the stock symbol for the initial offering of Twitter( TWTR).
J. J. Kinahan, chief strategist at TD Ameritrade, stated in Forbes,“ It’ s a perfect example of people not doing any homework whatsoever. Investing can be challenging, so don’ t put yourself behind the eight-ball to start.” Even a cursory investigation would have informed potential investors that Twitter was not publicly traded, having its IPO a month later.
Stock market success is the result of analysis and logic, not emotions. Overconfidence can lead to any of the following:
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Failure to Recognize Your Biases. Everybody has them, according to CFP Hugh Anderson. Being biased can lead you to follow the herd and give preference to information that confirms your existing viewpoint. Too Much Concentration in a Single Stock or Industry. Being sure you are right can lead to putting all your eggs in a single basket without recognizing the possibility that volatility is always present, especially in the short term. Excessive Leverage. The combination of greed and certainty that your investing decision is right leads to borrowing or trading on margin to maximize your profits. While leverage increases upside potential, it also increases the impact of adverse price movement. Being on the Sidelines. Those who feel the most comfortable in their financial capabilities often believe that they can time the market, picking the optimum times to buy, sell, or be out of the market. However, this can mean you will be out of the market when a major market move occurs. According to the DALBAR 2016 Quantitative Analysis of Investor Behavior, the average investor – moving in and out of the market – has earned almost half of what they would have made for the last 15 years if they had matched the performance of the S & P 500. J. P. Morgan’ s Roy notes that if an investor had been out of the market just the 10 best days over the past 20 tears – a span of 7,300 days – the return would be slashed in half.
Strategies to Stay Grounded Strategies to reduce the impact of overconfidence include:
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Spread Your Risk. While not a guarantee against loss, diversification protects against losing everything at once. Jim Cramer of TV’ s Mad Money recommends a minimum of 10 stocks and a maximum of 15 in a portfolio. Less than 10 is too much concentration, and more than 15 is too difficult for the average investor to follow. Cramer also recommends investing in five different industries or sectors. Investors should note that one benefit of mutual funds and ETFs is automatic diversification.
Buy and Hold. Warren Buffett is perhaps the most famous and ardent proponent of the buy and hold strategy today. In a 2016 interview with CNBC’ s On the Money, Buffett advised,“ The money is made in investments by investing, and by owning good companies for long periods of time. If they [ investors ] buy good companies, buy them over time, they’ re going to do fine 10, 20, 30 years from now.”
Avoid Borrowing. Leverage is when you borrow money to invest. And while leverage can magnify profits, it can also amplifies losses. It increases the psychological pressure to sell stock positions during