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Overconfidence problematic when investing

A while ago (2003), I wrote about a stock market study based on data at the height of the internet bubble (1999).

Two behavioral economists reported on the study, drawing conclusions about how investors act. Some of the insights are timeless.

First, while individual investors may react to attention-grabbing events, such as earnings releases, institutions are more likely to recognize the limitations of buying stocks in the news. If this sounds like you, there are other options.

Second, individual investors hold on to their losers. A better option is to watch trends. If the stock is underperforming its industry or sector, find out why. There may be better choices available.

If you step back and ask why investors might act in any of these ways, the behavioral economists suggest it may be overconfidence — that is, investors may be overconfident in their stock-picking ability and knowledge.

In fact, the economists pointed out that some professions might be more prone to exhibiting overconfidence, such as lawyers, physicians, engineers, investment bankers and entrepreneurs. And there might be gender differences as well, with more men exhibiting overconfidence than women.

What happens when overconfidence takes hold? Investors might hold riskier portfolios, trade too much and spend too much time and money on investment information. And they may be unrealistic about return expectations.

Let’s focus on return expectations in today’s market.

Since we are in a long bull market that started in March 2009, the overconfident individual might be taking a position now about the stock market. Let’s look at two extreme positions. One overconfident investor believes the market is too high and ready to collapse. Another is convinced the market has much more room to grow.

The reality is that no one knows. Fear can drive the skeptic, and, as Sam Stovall, chief investment strategist of U.S. equity strategy at CFRA, recently pointed out in “Stock Market Retreats and Recoveries,” fear also can drive the optimist: “It’s been said that fear and greed are the two emotions that drive the markets. However, one could argue that fear is the dominant emotion, since investors’ two greatest fears are losing money on the way down, and then missing out on the way back up.”

In today’s market, the answer is: If overconfidence is driving your decisions — especially if fear is the underlying emotion — now is the time to reassess.

Things are different today than when the study first came out. Individuals now have access to computerized screens offered by brokerage firms, such as Fidelity, and retail screening software, such as that offered through the American Association of Individual Investors. That availability can help individual investors do the type of screening that only institutions could do in 1999.

These screens help narrow the universe to those stocks that an individual needs to study. And study is what it’s all about. Being a successful do-it-yourself investor demands research, study and a good set of rules to follow in any type of market.

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