(exerpt from The Only Three Questions That Count, Ken Fisher, 2007)Throwing Spears — Overconfidence

While we are on the subject of hunting, another Stone Age behavior leading to investing errors is overconfidence. One behavioral lesson learned in recent decades is the average investor is markedly overconfident. He believes he has greater skill than he really possesses. This is parallel to the notion that 75 percent of drivers believe they are above average drivers. Overconfidence stems directly from accumulating pride and shunning regret over time. That is how we get overconfident. If Stone Age hunters weren’t nearly crazy with overconfidence, they would never attempt felling massive beasts with sticks tipped with a stone. They needed to fell those beasts or they would starve. Or be vegetarians — which was effectively the same thing.

For ancient hunter-gatherers, life was short and food was scarce. Consider recent findings regarding Kennewick man– a chap who lived roughly 9,000 years ago in what is now Washington state. (I always have sympathy for anyone named Ken and this guy needed sympathy.) Scientists discovered a spear head embedded in his hip. It wasn’t a death blow; this was a healed wound. He also apparently had multiple healed broken bones and other wounds. Life was tough for Kennewick man and his cohorts in 7,000 B.C. But it paid to take big risks– one big kill could mean a month’s protein for the tribe. Our ingrained survival instincts urge us to take risks– we frequently choose “fight” over “flight” when facing insurmountable odds. Think how many people persist in paying the stupid-tax, I mean, playing the lottery no matter how long the odds.

Investors by definition are overconfident when assuming they know more than they do– or when overestimating their skill level. Reading the Wall Street Journal and a handful of blogs and newsletters every day doesn’t make anyone an investing expert. Yet scores of otherwise intelligent people feel their ability to subscribe to and absorb common media makes them sufficient to bet and win. Investing is tough. There is an overabundance of highly educated and experienced professionals who invest as stupidly as rank amateurs. That doesn’t make getting in over your head any less dangerous.

Don’t mistake me. I’m neither advocating you dedicate your life to scholarly pursuit of investment knowledge nor hire a worthy professional. Quite the opposite! (Remember, all you need to succeed in investing is knowing something others don’t, and for that you need only the Three Questions.) Rather, you should beware overconfidence because it leads to very serious errors– the same errors everyone else makes.

For example, overconfidence leads investors to invest in an “Initial Public Offering” (IPO; for the neophyte, IPO alternately means “It’s Probably Overpriced”) of stock, micro-caps, hedge funds, and other volatile or illiquid interests while ignoring or downplaying the associated risk. Think about how often you’ve heard pundits, friends, or your broker describe an opportunity as the “next Microsoft.” The odds are stacked against you– precious few new businesses survive, much less blossom into a hot stock.

Overconfidence may lead you to hand onto a stock, hoping it will someday bounce back, even when mountains of evidence contradict it. If you bought Level 3 at $130, and insisted to your sobbing wife when it fell to a buck and a half that it’s a great firm and will bounce back one day– you were shunning regret and displaying overconfidence.

Behaviroalists note one common investor tendency is holding onto a stock hoping it gets back to “breakeven”– refusing to sell until then. Everyone in money management and every stockbroker knows many clients who rush to sell a stock they’ve been holding onto with a loss as soon as it gets back to breakeven. By refusing to sell until then, the breakeven investor mentally refuses to acknowledge the loss and therefore postpones having to absorb full regret. It’s human nature to think you haven’t made a mistake and refuse to cut losses. No doubt, selling a stock just because it drops in price is a loser’s strategy. But sometimes you must admit you’ve erred and your money is better placed elsewhere.

Overconfident individuals often own too few stocks– maybe just a handful. You might work for a company that allows you to buy its stock as part of your retirement plan. Your overall allocation of your company stock (or any stock for that matter) should not be more than 5% of your overall portfolio. If it is, you are being overconfident unless you really do know something material others don’t. Most folks who do this don’t know anything others don’t know.

No company, no matter how seemingly robust and healthy, is guaranteed not to lose stock value. Investors load up on company stock because they’ve heard examples where it worked because some single stock was spectacularly successful. They forget about the backfires. Investors say things like, “But I’m comfortable holding this stock because I know the company.” You may be an astoundingly productive accountant, but as fabulous as you are, your presence doesn’t grant immunity from market depreciation to your employer.
Credits: This article is extracted, with modifications, from The Only Three Questions That Count by Ken Fisher (Wiley Finance, 2007).