One of the most documented of all psychological errors is the tendency to be over optimistic. In general, most people do not see the need to improve the way they make decisions, as they believe that they are already making excellent decisions. The unwarranted belief that we are usually correct is a major real-life barrier to critical thinking.
People exaggerate their own abilities and this is particularly common in managing their assets. Overconfidence often results in investors being fooled by small gains in a few trades, feeling much more in control of a situation than they are. Money managers, advisors and investors are consistently overconfident in their ability to outperform the market, but fail to do so.
For example, mutual fund managers, analysts, and business executives at a conference were asked to write down (1) how much money they would have at retirement and (2) what is their net worth now. The average figures were $5 million and $2.6 million respectively. The professor who asked the question said, “regardless of the audience, the ratio is always 2:1”. People are definitely very confident that they will at least make more money in future than now.
Overconfidence can lead to the followings:
1. Not having an investment plan
Perhaps the most common reason why investment plans fail is that the investor doesn’t actually have a plan. The very first step of a rational investor is to draft a plan stating investment goals and conditions. This is to make you detached from the whole investment business and follow strictly by the book not your heart.
2. Overtrading
In Odean and Barbet’s study of 78,000 investors’ accounts in a large brokerage firm from 1991-1996, the most active traders scored an average return of 10% compared to the less active investors’ 17.5% profits. And online traders suffer even lower returns as they tend to overtrade and thus lose money to brokerage charges.
3. Lack of diversification
Due to overconfidence, investors tend to invest heavily on a particular investment with the optimism that it will generate good returns. This lead to insufficient diversification of portfolios.
In general, overconfidence is caused by mental bias that leads investors to over-estimate their knowledge, under estimate the risk and exaggerate the control they have over a situation.
Happy investing,
Pauline Yong
Tuesday, June 28, 2011
Sunday, June 5, 2011
What happens when an economist fails to predict?
There was a famous economist, who was also a Yale professor who was once a very successful man, driven by chauffeured limousine, owned $10million worth of stocks but because he made a blunder in his macroeconomics view he lost all his fortune and died in poverty! He was known as the Milton Friedman of his time, the premier monetarist – Irving Fischer, the man who contributed to the Quantity theory of Money.
Where did he go wrong? During the 1920’s the U.S. was enjoying the fruits of the industrial revolution with new technology and new consumer products, one of them was the mass production of the Ford T model. Fischer believed in this new era and he was too optimistic about the macroeconomic data at that time. He was famous for having made a statement one week before the crash, on October 16th, 1929: "Stocks appear to have reached what appears to be a permanent plateau." He argued that stocks could not go down, and economists have had to live with that.
As a great economist he failed to see the Great Depression was coming and as a result, Irving Fischer lost his entire fortune. He was totally wiped out of his $10 million, and in the late 1940's his financial situation was so dire that Yale University had to buy his home and rent it back to him for free. When he died, he died in poverty and disgrace.
Do economists have more prediction power than the rest when it comes to guessing the direction of the market? In my personal view, I think stock investing is an art. There’s no fixed rule for it and definitely we can’t just rely on facts and figures to make decisions. Having an economics degree or a finance degree doesn’t mean you can do well in the stock market. What most investors need is a combination of experience, luck, knowledge and most importantly, good analytical skills.
I’ve been pondering how well I can predict the stock market too. In 1996, I saw the super bull run in Malaysia and thought we were really the “tigers” of Asia. However my dad told me something that I will never forget! He said it could be a bubble. I was very puzzled and he explained to me further how the asset bubble was formed and how the houses were in over supply at that time because everyone thought they could make money from assets and not from production!
Rober Kiyosaki said he has a rich dad and a poor dad, but I always tell people I’ve a “Wise Dad”! I learned about the virtue of value investing from my dad because I saw how his portfolio ballooned to hundred folds when he invested during the 1997-98 Asian financial crisis. My dad doesn’t have economics or finance background, but he graduated from University of Malaya with Engineering degree. To me he’s a very successful investor. Through my dad, I think I’ve found the key factor to success in stock investing, which is:
KNOWLEDGE + ANALYTICAL SKILL + VISIONARY
Having knowledge alone is not enough, because knowledge is just a source of information. We need further analysis to get to the possible effects of the source. And we must have a visionary perspective of the whole situation to see the bigger picture.
Irving Fischer was a knowledgeable man and I’m sure his analytical skill was superb but what he lacked was “visionary”. He was unable to see the bigger picture into the future and was blinded by the rosy scenario in Wall Street.
As for me, I’m still learning. If I continue to polish my skills through learning from successful people I believe I’ll have more successful and rewarding investment in years to come.
Happy investing,
Pauline Yong
Where did he go wrong? During the 1920’s the U.S. was enjoying the fruits of the industrial revolution with new technology and new consumer products, one of them was the mass production of the Ford T model. Fischer believed in this new era and he was too optimistic about the macroeconomic data at that time. He was famous for having made a statement one week before the crash, on October 16th, 1929: "Stocks appear to have reached what appears to be a permanent plateau." He argued that stocks could not go down, and economists have had to live with that.
As a great economist he failed to see the Great Depression was coming and as a result, Irving Fischer lost his entire fortune. He was totally wiped out of his $10 million, and in the late 1940's his financial situation was so dire that Yale University had to buy his home and rent it back to him for free. When he died, he died in poverty and disgrace.
Do economists have more prediction power than the rest when it comes to guessing the direction of the market? In my personal view, I think stock investing is an art. There’s no fixed rule for it and definitely we can’t just rely on facts and figures to make decisions. Having an economics degree or a finance degree doesn’t mean you can do well in the stock market. What most investors need is a combination of experience, luck, knowledge and most importantly, good analytical skills.
I’ve been pondering how well I can predict the stock market too. In 1996, I saw the super bull run in Malaysia and thought we were really the “tigers” of Asia. However my dad told me something that I will never forget! He said it could be a bubble. I was very puzzled and he explained to me further how the asset bubble was formed and how the houses were in over supply at that time because everyone thought they could make money from assets and not from production!
Rober Kiyosaki said he has a rich dad and a poor dad, but I always tell people I’ve a “Wise Dad”! I learned about the virtue of value investing from my dad because I saw how his portfolio ballooned to hundred folds when he invested during the 1997-98 Asian financial crisis. My dad doesn’t have economics or finance background, but he graduated from University of Malaya with Engineering degree. To me he’s a very successful investor. Through my dad, I think I’ve found the key factor to success in stock investing, which is:
KNOWLEDGE + ANALYTICAL SKILL + VISIONARY
Having knowledge alone is not enough, because knowledge is just a source of information. We need further analysis to get to the possible effects of the source. And we must have a visionary perspective of the whole situation to see the bigger picture.
Irving Fischer was a knowledgeable man and I’m sure his analytical skill was superb but what he lacked was “visionary”. He was unable to see the bigger picture into the future and was blinded by the rosy scenario in Wall Street.
As for me, I’m still learning. If I continue to polish my skills through learning from successful people I believe I’ll have more successful and rewarding investment in years to come.
Happy investing,
Pauline Yong
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