INVESTMENT OVERCONFIDENCE

(Simon Gervais & Terrance Odean) You have read my previous comments about the inability of individual investors to really understand what they are doing. Basically, if they do not know what the fundamentals of investing are- alpha, beta, correlation, diversification, Sharpe ratio etc., then you are primarily kidding themselves about their inherent capabilities. Secondly is my (slightly) irreverent definition about the male ego and is effect on investing:

MALE EGO: A genetic mutation that flourished. Responsible for more bad investments and bad investment decisions than any tax law changes by Congress. Though usually noted in the male species, females are also prone to its insidious faults- lack of reading and adequate research followed by defective decision making based on insufferable narcissism and the rationalization it was someone else's fault when the investment tanks. Used a lot by stupid people or intelligent people acting stupid. Caution advised when using this as the main rationale for investing.

Lastly is the oft repeated psychological effect of losses-

PEOPLE ARE A LOT MORE LOSS ADVERSE THAN THEY ARE RISK ADVERSE.

Gervais and Odean did a survey in 1997 of many investors. While their comments are in more fluid terms than mine, you'll see they simply match my comments of many past years.

They referred to the fact that a novice investor does not know why he/she is successful until enough time passes so that they can gauge how they are doing by the increases or decrease of their portfolio. They noted that they take too much credit for their successes and take less responsibility for the losses. Therefore the overconfident man (usually a man so I will dismiss the "she" in further commentary) tends to become more risky in the investment orientation than his ability sustains. "An overconfident trader trades too aggressively, thereby increasing trading volume and market volatility." "Overconfidence does not make traders wealthier, but the process of becoming wealthy can make traders overconfident."

The problem that I see is that such overconfidence in this type of market is invariably due to luck- not skill- or at least limited skill. And should they take such overconfidence into retirement and the market changes, they can then put their families into an untenable financial situation when the risky investments possibly fail- or at least exhibit too much volatility for retirement use.

In terms of losses- Tversky and Kahneman noted in as early as 1979 that "contrary to expected utility theory, people placed different weights on gains and losses and on different ranges of probability. They found that individuals are much more distressed by prospective losses than they are happy by equivalent gains." They noted that some economists think people are twice as likely to feel the pain of a loss than the joy of a gain. context of losses or gains. And from their 1979 article they "found that people are willing to take more risks to avoid losses than to realize gains. Faced with sure gain, most investors are risk-averse, but faced with sure loss, investors become risk-takers."

Additionally- and noted here previously- people have a tremendous aversion to selling a stock or fund that is doing terrible- even when presented with all the fact indicating the lowered ranking by independent services. Professor Statman is an expert in the behavior known as the "fear of regret." "People tend to feel sorrow and grief after having made an error in judgement. Investors

deciding whether to sell a security are typically emotionally affected by whether the security was bought for more or less than the current price. One theory is that investors avoid selling stocks that have gone down in order to avoid the pain and regret of having made a bad investment. The embarrassment of having to report the loss to the IRS, accountants, and others may also contribute to the tendency not to sell losing investments." I have often found another issue- emotional or sentimental familiarity. Some "investors" may have been given stock by a family relative, a deceased member of the family, through a divorce, etc. The emotional attachment may preclude them from selling since the benefactor- though possibly deceased- would think less of them.. Same scenario where so many employees are using employer stocks- primarily in 401(k) plans. The attachment to their work precludes selling a stock that may well be fundamentally flawed but where they are actively involved with the company that they "cannot possible consider" a sale. As proof, consider Digital. Once a solid company with value escalating from the mid 30's to $200 per share, it plummeted to as low as $16 a share before recovering only slightly. But I know of some that did not even remotely diversify when presented with independent Value Line ratings of D.

Statman also acknowledged the "conventional wisdom to avoid the possibility of feeling regret in the event that their decisions prove to be incorrect. Many investors find it easier to buy a popular stock and rationalize it going down since everyone else owned it and thought so highly of it." (That's the standard "herd mentality" that many articles comment about.)

As regards my MALE EGO, the professors noted that "People are overconfident in their own abilities, and investors and analysts are particularly overconfident in areas where they have some knowledge. However, increasing levels of confidence frequently show no correlation with greater success. For instance, studies show that

MEN CONSISTENTLY OVERESTIMATE THEIR OWN ABILITIES IN MANY AREAS INCLUDING ATHLETIC SKILLS, ABILITIES AS A LEADER, AND ABILITY TO GET ALONG WITH OTHERS.

Money managers, advisors, and investors are consistently overconfident in their ability to outperform the market, however, most fail to do so. (That's why the use of index funds is, to some degree- valid investing asset allocation.) "In summary, people trade for both cognitive and emotional reasons. They trade because they think they have information when they have nothing but noise, and they trade because trading can bring the joy of pride. Trading brings pride when decisions turn out well, but it brings regret when decisions do not turn out well. Investors try to avoid the pain of regret by avoiding the realization of losses, employing investment advisors as scapegoats, and avoiding stocks of companies with low reputations."

The different "spin" I put on the commentary is the reference to the use of the term "investors". These people are NOT investors- they are novices with limited background and skills and with a lot of emotional baggage they bring to the "game". For all intents and purposes, there is no emotion to investing. It is simply research of numbers and estimates of company and worldwide economics. If you play it any other way, you still might reach high financial goals. But it was undoubtedly due to luck and extra risk- not skill. Will you be lucky?????