by Christopher Rowe, Investment U Research
Thursday, February 27, 2014: Issue #2238

Have you ever stuck with a losing stock position because you were overly confident that the Street had it wrong and it was sure to come back? The painful mistake is so clear… in hindsight.

This is because trading and investing psychology is the single-strongest indicator of stock market profits or losses. You can watch two investors using the same exact “proven system” or investment philosophy and find two very different results at the end of the year.

Your best bet is to avoid overconfidence at all costs. Sure, this may be the hardest habit to break. But you already have a head start if you’re not a professional.

Here’s why…

Overconfidence is particularly pronounced among experts as opposed to amateurs. One study found that 68% of analysts thought they were above average at forecasting earnings; 75% of fund managers thought they were above average at their jobs.

Yet research shows that the absolute worst performers are generally the most overconfident. One study from Cornell University, for example, found that those who are overconfident “suffer a double curse of being unskilled and unaware of it.” They are too confident about their ability to make predictions, and typically have the “illusion of knowledge” driving that overconfidence.

Remarkably, these inept forecasters continue to forecast even after seeing overwhelming evidence that they aren’t good at it. This can be explained as ignorance (not knowing the overconfidence exists) and arrogance (“ego defense mechanism”).

In separate research by Gustaf Torngren and Henry Montgomery, two groups of participants were asked to choose which of two well-known blue chip stocks was going to perform better in a given month. The first group was composed of amateurs (psychology undergrads) and the second group was made up of professional portfolio managers, analysts and brokers.

Each group was given the name, industry and previous 12 months’ performance for each stock. The chart below tells the tale…

The students were 59% confident in their stock-picking abilities on average and the professionals averaged 65% confidence. Obviously the lay people outperformed the professionals by a large margin.

But a deeper look at the data is even more eye-opening. When the professionals were 100% sure they were correct, they were actually right less than 15% of the time! The amateurs, on the other hand, never declared themselves 100% confident.

Avoid the Trap

There are three easy ways to avoid overconfidence and bias.

The first is to always understand both the bullish side of the argument and the bearish side of the argument. They both always exist. It’s just a matter of which side has the volume turned up at any given time.

At some point your stock will decline because people are more focused on the bearish argument. If you try to find the bearish arguments for your positions ahead of time, it can keep you on an even keel and help to avoid getting caught up in the hype.

The second is to implement stop loss orders, which automatically trigger the sell order when the stock falls below a certain price. On long-term positions, you can keep a trailing stop loss as high as 25%. At least this way, you don’t have to fight with yourself about when or where to exit the position. The longer-term your position is the easier it can be to deal with natural price fluctuations.

The third is to hedge your positions. There are many ways to hedge. Two simple ways are:

Take some bearish positions on stocks that you think are going to tank. It’s best to focus on stocks and sectors that have been underperforming the general stock market for the last six months. They are likely to continue underperforming.

Purchase protective put options on your bullish positions. Which ones? Preferably put options that expire six to nine months out and that have a strike price approximately 20% lower than the underlying stock’s current price. So if your stock is at $100 per share in January, you would look to also buy the September $80 puts (traditionally, one put for every 100 shares).

Selecting winning stocks is only part of the battle. Investing psychology and proper risk management is an even bigger component in the path to profitability. In the financial markets, bias is the enemy and humility is your friend.

Good investing,

Chris