Paying a price for overconfidence

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Mar 13, 2011
small change
Paying a price for overconfidence

Even seasoned investors slip up sometimes, so always think through an investment decision
By Gabriel Chen, Finance Correspondent

I made my first investing mistake in 2001 because I was too confident.

When I was 21, I had saved a small sum of money from my national service stint and decided to do something meaningful with it.

I visited a bank and asked the relationship manager there to apportion my money in a technology fund and a biotechnology fund.

I reasoned that tech stocks were cheap since the dot.com bubble had just burst a year earlier. And with Singapore starting to transform itself into a hub for the biomedical sciences, riding on the biotech wave would not be a bad idea. Unfortunately, things did not turn out the way I had envisioned.

Both funds performed so terribly that I decided to cut my losses and redeem my units several years later.

Looking back, it was due to my overconfidence that I had taken such a slipshod approach.

I had not adequately considered the funds' expense ratios (annual fees charged by all funds), sales charges and turnover (how long a fund holds on to the stocks it buys).

I could also have read more about the managers in the fund prospectus and annual report, or studied the investment reports before committing to the funds.

While overconfidence is particularly a problem with novice investors, even experienced investors become overconfident about their own abilities.

Take Long Term Capital Management (LTCM), a hedge fund that was run by extremely smart people, including Nobel Prize winners.

They were so confident that they believed the most they could ever lose in a single day was US$35 million (S$44 million). But on Aug21, 1998, they lost US$553 million.

LTCM ended up losing US$3 billion in 1998 and was bailed out by a group led by the Federal Reserve Bank of New York.

Research has shown that most people have an exaggerated sense of their own capabilities.

Optimism is not always bad. People would have a hard time dealing with life's many setbacks if they were diehard pessimists.

But when it comes to investing, the cost of mistakes rises as one's level of overconfidence increases.

Overconfident investors trade more rapidly, because they think they know more than the person on the other side of the trade.

Consequently, they earn less than those who opt for a buy-and-hold strategy.

The next time you are about to make an investment decision because you are sure you are right, take time to have what I call the overconfidence conversation.

Tell your spouse, partner or anyone you trust about your investment plan, the level of risk involved in the investment you are contemplating, and how you think you will be adequately compensated for that risk.

You should also realise that there are millions of smart investors in the marketplace analysing the same data you have access to.

To avoid overconfidence in my investing, I try to achieve adequate portfolio diversification.

To be sure, there are people who have made fortunes by betting big on one or two hot stocks.

But I always tell myself that even if I am right nine out of 10 times, one bad mistake could see me lose everything.

Hence, diversification is key for me, so that I can do fine even if I am wrong.

Conversely, while overconfidence is deadly, the lack of confidence can be paralysing.

Underconfidence can feed the 'herd instinct' because investors become easily influenced by what other people say without checking if they can be trusted.

Therefore, what investors should do is to strike a balance between overconfidence and underconfidence.

I recently read the memoirs of Mr Sandy Weill, Citigroup's creator and former chief executive, and found some sound advice on how to develop good self-confidence.

First and foremost, it is about realising that losing can actually be a good thing.

Mr Weill described how in 1997, he was negotiating extensively with his company Travelers Group to merge with US bank JPMorgan, but the talks floundered when the latter's chairman insisted on an unreasonable management structure.

Mr Weill felt disappointed, but less than a year from the end of those talks, his firm bought Salomon Brothers and created Citigroup via a merger with Citicorp.

In the end, Mr Weill ended up with a global powerhouse that far exceeded anything he might have hoped for had he combined with JPMorgan.

Mr Weill writes: 'I've had plenty of failed merger negotiations and have made my share of mistakes over the years, but there's one thing I learnt early: Don't dwell on defeat. Usually, a better deal has a way of coming along.'

So the next time you make an investment decision, remember that successful investors seek to find a balance between rashness and timidity.

Self-confident investors also recognise the way they deal with loss and failure is as important as, if not more important than, the way in which they deal with success.

gabrielc@sph.com.sg

My Value Investing Blog: http://sgmusicwhiz.blogspot.com/
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