STREET DOGS

From Dan Solin at HuffPost and US News: The next time you’re tempted to buy or sell stock because you believe it’s mispriced, think about the assumptions you are making.

First, you are assuming the price set by millions of traders all over the world (who are looking at the same information about the stock as you have) are wrong. You would have to believe they missed something that makes the price of the stock too high or too low.

Second, if you are buying, someone else is selling. They obviously believe it is a good time to sell. How confident are you that they are wrong and you are right?

Third, you don’t have the benefit of knowing who is on the other side of the trade. Would you bet on the outcome of a sporting event without knowing all of the participants in the game? If you are buying, would it make a difference if you knew Goldman Sachs was the seller? How likely is it that you would know more than Wall Street insiders?

Unfortunately, many people abandon any pretence of objectivity when it comes to investing. They are overly confident in their ability to achieve returns that will beat the market. Such investors are not alone.

A 2006 study by James Montier surveyed 300 professional mutual fund managers. Nearly 75% of them thought they were above average at their jobs. Few, if any, believed they were below average.

Another study, authored by Terrance Odean in 1998, examined what happens when investors are overconfident. It found that they expend too many resources on information acquisition and trade too much. The study concluded that the pursuit of information deemed necessary to increase returns caused overconfident traders to “fare less well than passive traders”.