Overconfidence is the nemesis of many an investor and trader
• Discipline is a vital quality that can counterbalance overoptimism and help prevent losses
There are two things that kill the fortunes of most investors: a lack of discipline and overconfidence. A prerequisite for success in most fields is control.
But traders work in an environment over which they have no control, matched by an almost limitless freedom of choice. With sufficient capital, they are free to buy or sell any number of instruments, in any amount, at almost any time.
What traders can control, however, are their choices. “The one thing I can think of that most affects both trading and investing has to be self-discipline,” says Joe Ross of Trading Educators Inc.
“Being disciplined is fully 50% of the job of trading or investing. I don’t care how good your system is, without the discipline needed to follow it through you don’t have much chance of success. Discipline involves self-control.”
Self-control is more vital as natural compulsions conspire to defeat traders.
If success in trading could be achieved by doing what comes naturally, the only prerequisite would be sufficient capital. As that is not the case, native instinct must somehow mislead. And it does.
Every trading error is the result of doing what comes naturally: taking profits too quickly; holding losers too long; averaging down; acting on a rumour; loading up on a sure thing.
But while self-control is essential, it has a downside.
As Maria Konnikova, a doctoral graduate in experimental psychology at Columbia University in the US, who won more than $200,000 after she began studying poker for a book she’s researching, explained in a recent interview with the New York Times: “I wanted to see if people with high levels of selfcontrol made better decisions in risky conditions, like in the stock market.
“Usually, people with high self-control do so much better at everything than people with low self-control. But it ends up that in unpredictable environments like the stock market, successful high self-control people — when in an environment where control is taken away from them — take longer to figure things out. They are too confident and won’t take negative feedback from the environment.”
Konnikova said: “People with lower self-control and who aren’t as successful. they’re like, ‘Uh oh, a bad thing is happening. I guess I should actually figure that out’.”
Bent Flyvbjerg, a professor at the Saïd Business School at the University of Oxford, is an expert on the so-called optimism bias, with a strong interest in how overconfidence affects investors. “Most have unrealistic expectations about their own abilities at picking stocks and timing the market, and about the results they’re likely to achieve,” he says. “We know from solid research that overoptimism is rife in the financial industry, it’s widespread, and it’s one of the things you need to guard yourself against as an investor — both your own optimism, and other people being overly optimistic with your money. That can lose you a lot of money.”
Confidence may well be an essential ingredient for success in the market, but overconfidence
is a problem. In his book, The Stock Market Wizards, Jack Schwager notes that one of the most strikingly evident traits among all the market wizards is their high level of confidence.
“The more interviews I do with market wizard types,” he says, “the more convinced I become that confidence is an inherent trait shared by these traders, and is as much a contributing factor to their success as a consequence of it.”
When Steve Watson was asked what gave him the confidence to pursue a career in money management when he had no prior success picking stocks, he replied: “Once I decide I am going to do something, I become determined to succeed, regardless of the obstacles. If I didn’t have that attitude, I never would have made it.”
Michael Masters, who launched his fund when he was an unemployed stockbroker with virtually no track record, said he realised that if somebody else could make money trading, so could he.
Michael Lauer was almost apologetic about his confidence when he decided to switch careers from analyst to money manager: “I hesitate to say this because I don’t want to sound arrogant, but one of the things that gave me confidence in going on my own was that fund managers were my clients when I was an analyst, and I thought they would not be particularly difficult to compete against.”
Schwager says an honest self-appraisal of confidence levels may be one of the best predictors of a trader’s prospects for success.
“Everybody hopes to have a windfall in the financial markets,” says Flyvbjerg, “especially inexperienced beginners, who still think they’re going to be better than the average investor.
“The hardest thing to learn is not to be too optimistic. It’s really difficult. It takes a lot of time, and a lot of experience, and there are very few investors out there who have this cool realism that will make you successful as an investor….
“With professionals there’s actually an additional bias — in addition to optimism bias — because they have a deliberate interest in making people believe they can do better. It’s what we call a strategic bias.
“Professional investment managers try to make clients believe that they’re better than the markets, and again it’s been shown that on average you’re better off without a professional investor than with one.”
Flyvbjerg says the solution is to avoid making subjective decisions. Optimism bias has to have an opportunity to kick in and only does so when subjective decisions are made.
THE HARDEST THING TO LEARN IS NOT TO BE TOO OPTIMISTIC. IT’S REALLY DIFFICULT. IT TAKES A LOT OF TIME