Saturday, February 09, 2008

Behavioural Finance Part 2 - Over-Confidence

Part 1 of the behavioural finance series talked about the effects of mental accounting and how it can distort our perception of money and influence our decision-making process. The second part of this series touches on a very common problem among human beings, that of over-confidence. Over-confidence is an insidious condition which can rob a person of normal rationality and cause him to take risks larger than what he is supposed to be comfortable with. Thus, this figures high on the list of behaviours to watch out for when investing in the stock market.

According to the book "The Essential Buffett" by Robert G. Hagstrom, an overwhelming majority of people (when interviewed) claimed that they were good drivers, which leaves one to wonder where all the bad ones are ! Also, according to him, doctors state that they can diagnose pneumonia 90% of the time while the actual percentage is closer to only 50%. These examples show that human beings have the tendency to over-estimate their abilities and to feel that they are superior to other human beings. The truth is, of course, that only a minority of people are actually very good and consistent when it comes to stock market performance; and these are the people who understand about temperament and emotions and learn to master them instead of letting their emotions take control.

Confidence itself is a good thing when it comes to investing, as it implies that one is certain and confident of his investment strategy and that he can execute it competently enough to ensure consistent profits for his investments. Over-confidence is excessive confidence in one's ability and can lead to one making silly and stupid mistakes as a result of an inflated ego. But just how does over-confidence manifest itself during investing ? Some examples would include someone "getting it right" a few times in a row when it comes to picking "winners", thus he feels that he has found a secret formula or that he can do no wrong. Therefore, he recklessly picks his next few investments and plonks large amounts of money into them, only to lose massive amounts of cash in the process.

Another example of over-confidence may be someone who thinks he has stumbled on a secret "system" to beat the market every single time, and thus far it has worked very well and generated consistent profits. One instance of this behaviour was highlighted in a New Paper article showing how an Singaporean under-grad studying in Australia had managed to make a small sum from "contra" trades, only to lose an amount close to S$700,000 over three months after over-confidence took control of his senses. There have been forumers on various share forums in Singapore who also displayed excessive optimism on their own stock picking abilities, only to fall prey to the moods of Mr. Market which their "perfect" system could not detect swiftly enough.

Personally, I have also been guilty of being over-confident at times, as this is a perfectly human trait and we are not infallible. At such times, I have to constantly remind myself not to gloss over the facts of the case and to remain focused; because even though I have had some success in picking good companies, it does not mean that I will ALWAYS be successful in picking good companies. Being mindful of one's fallibility makes one more humble and also allows one to admit mistakes made, in order to learn and improve on one's investment acumen.


donmihaihai said...

Some insights from Charlie Munger and Bruce Berkowitz

trying not to be over confident is one of the hardest because many times, it is only known after not before the event happened.

Charlie Munger gives ways to avoid is to invert. Think back from conclusion to starting point to see the whole process of thinking backward at the same time thinking whether congitive errors and over confidence are being made.

Bruce Berkowitz, another superinvestor trys to "kill" the company after the initial conclusion is made. If that company cant be kill, it is something.

MM said...

Hi MW,

Interesting piece. If you like, you might want to consider reading the book The Only 3 Qns that Count by Ken Fisher. In it, he also talks bout the primitive brain with regards to investments.

As I reviewed my trades/investments in 2007, my biggest mistakes were to think that my reasoning is correct and the market is wrong...

The market is never wrong... though it can be manic depressive at times... like now.. and stay that way for quite some time, and I will get my money tied up in securities that might not show its true value for a long time to come.

Hence, I fine tuned my new investment rules to never hold any stocks thro' a correction.

I read your comments on How to make money in stocks by Bill O'Neil. I strongly encourage you to read the book with an unbiased view before you decide....

It has really helped me to be able to time the market and get out prior to any correction.

As far as I am concerned, all stocks are bad and speculative, unless they go up in price. I buy them to make money, not to prove that I am wrong and the market is wrong.

Have a happy CNY ;)


MM said...

Sorry, I mean to say "I buy them to make money, not to prove that I am right and the market is wrong."

musicwhiz said...

Hi donmihaihai,

Wow, thanks for the quotes, they are good ones ! Thanks for visiting as well. :)



musicwhiz said...

Hello MM,

Yes, I've seen that book by Ken Fisher but have not had time to browse through it as I am currently reading another book. Haha so many books, so little time !

It is also true that the market can stay irrational for long periods of time, which is why most of the time I just ignore it and stay focused on my companies' businesses. Whether this will work in the long run remains to be seen, but I hope my framework will prove me right or I would have wasted quite a bit of time haha :P

Good idea as well to check out that book by O'Neil. I have also seen it on bookshelves but have not had a read yet.

Thanks !