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Trading Doctor- The Danger of Overconfidence

InvestorEducation / Learn to Trade Jun 03, 2008 - 09:59 AM GMT

By: Dr_Janice_Dorn

InvestorEducation

Best Financial Markets Analysis ArticleThere are two kinds of people that lose money: those that know nothing and those that know everything. With two Nobel Prize winners in the house, Long Term Capital Management fits the second case…R. Lenzner, Forbes Magazine, October 19, 1998

Once upon a time there was a secretive hedge fund called Long-Term Capital Management (LTCM). Over a period of four years—from 1994-1998 this hedge fund returned approximately 40% per year. Then, in 1998, the LTCM portfolio dropped from US$100 billion to US$600 million. In order to avoid a potential market crash the U.S. Federal Reserve organized a consortium of investment banks to take over LTCM's positions in various financial instruments. The failure of LTCM is a cautionary tale about hubris, arrogance, overconfidence and the limits of modern financial theory.


TTD MAY NEWSLETTER  OVERCONFIDENCE   animate.jpgJohn Meriwether founded LTCM. Although what actually happened is not clear, it appears that he was forced to leave Salomon Brothers in connection with a trading scandal. He could have walked away and retired, but—as we all know from Wall Street history—this rarely happens. Trading is like a fire in the blood and Meriwether had a ton of fire.

It seemed that the new fund was destined for success. Meriwether, who was trained in physics and mathematics, was one of the first traders to bring quantitative finance to Wall Street. He was the Mr. Spock of trading—cool, calculating, totally rational and intellectually brilliant. Meriwether's team included Nobel-prize winning economists Myron Scholes and Robert Merton, as well as David Mullins, former vice-chairman of the Federal Reserve Board who left his job to become a partner at LTCM. Meriwether also brought some excellent traders from Salomon Brothers. 

The impressive credentials of the genius team of LTCM convinced 80 investor clients to put up the minimum investment of US$10 million each. The fund started in 1994 with a total equity of $1.3 billion. That was a significant amount of money for a start-up hedge fund in 1994! Clients included Bear Sterns President James Cayne; Merrill Lynch purchased a significant share to sell to clients, including a number of executives and its own CEO, David Komansky. 

This auspicious team then proceeded to build trading models based on the assumption that markets were logical and would always tend toward equilibrium. They were absolutely convinced that they could not fail. (I wish I had been there to smell the hubris in the air, but, alas, I was still a fledgling trader trying to slog it out in the futures market and getting my own Ph.D. in losses during that time!) 

From 1994-1996, LTCM returned 40% a year and their funds swelled to US$7 billion. They made huge financial bets in thousands of market positions, and—for four years—showed excellent returns. Then, they crashed and burned, endangering the US financial system. In his book titled, Inventing Money: The Story of Long-Term Capital Management and the Legends Behind It , Nicholas Dunbar describes how LTCM ignored two underlying assumptions behind the market models they used. These assumptions were:

• Markets are always liquid (i.e., you can always sell an asset at a reasonable price). 

• Markets tend toward equilibrium, where "mispricings" are corrected. 

What they failed to take into consideration was that during market panic, liquidity dries up as investors move their money to safer investments. While market equilibrium may be true in the long run, mispricings can persist for periods of time resulting in losses of billions of dollars. 

You knew I would eventually get to the psychology of Mr. Meriwether, so here it comes! The most brilliant quantitative financial and academic financial minds were no match for the psychology of Mr. Meriwether. Why? Because he was so confident about his market opinions. If he believed that the market would go in one direction and it went against him, he would not change his opinion. Often, he would increase the size of his position. If his mathematical models showed a mispricing, he remained confident that fair value would, over time, return—so he kept his position or added to it. 

As is so often the case in the markets, other traders were able to figure out what LTCM was doing and began to copy the trades or find ways to trade against them. Slowly, the power of LTCM began to unravel as they started to look for new markets where others might not be able to mimic them. LTCM made the fatal assumption that these new markets operated in the same way that the others markets did. They continued to add to losing positions, taking on more and more risk, adding more leverage (it is said that they borrowed US$50 for every US$1 invested), and spreading themselves too thinly across too many markets. 

Indeed, the genius team was spreading itself across thin ice and skating very fast to avoid cracking the ice. They failed and fell hard into the freezing water below. 

During three months in 1998, LTCM lost 90% of its assets and was unable to meet the US$1.3 trillion margin call on thousands of outstanding positions. One dollar invested in LTCM was worth about 25 cents and their collapse nearly caused a total meltdown of the global financial system. By the fourth quarter of 1998, the damage from LTCM's near-demise was widespread. Many banks took substantial write-offs as a result of losses on their investments. UBS took a third-quarter charge of US$700 million; Dresdner Bank AG a US$145 million charge, and Credit Suisse US$55 million. Additionally, UBS chairman Mathis Cabiallavetta and three top executives resigned in the wake of the bank's losses, as did Merrill Lynch's global head of risk and credit management. 

So serious and near catastrophic was this situation that, in 1999, President Clinton published a study of the LTCM crisis and its implications for systemic risk in financial markets, titled The President's Working Group on Financial Markets Governance and Risk Control-Regulatory Guidelines .

Today, LTCM's losses may not seem like a lot of money. However at that time, the amounts were large enough to send the entire global financial community into terror and require new regulation. 

In the massive media coverage surrounding this event, the emphasis was on the psychological underpinnings of the demise of LTCM. After several years of astounding success in returning 40% a year, the logical, rational, quantitative, Nobel prize-winning geniuses became infected. The virus was a combination of pride, arrogance, defiance, greed and hubris. I call this the Rat Brain Virus . These giants of finance were unable to get their trading brains out of the cave . Emotions and absolute conviction that their quantitative models were correct led to one of the most tragic incidents in the history of the financial markets and one that rocked the world.

Did Meriwether, then 60 years old and at the helm of a massive financial disaster decide to give it up, walk away, and retire to a desert island? No, he did not.

Fire was still in his blood and in his belly. Meriwether now runs a bond portfolio that is down over 25% in 1998 and an equity portfolio that is down some 6% this year (percentages are approximate as of this writing). Both portfolios had poor performances in 2007. Some investors are seeking to get their money out. Mr. Meriwether and his colleagues at JWM Partners LLC—which he launched in 1999 with LTCM alumni—are trying to reassure investors in the two funds that they have slashed risk and will use their experience to survive this market crisis, preserving about US$1.4 billion in assets. 

Meriwether has seen three decades of market zigzags, recessions and credit contractions. Yet he wraps his brain around the volatility of these markets and is still a victim to his rat brain. I have never met Mr. Meriwether, so this is not a personal assessment. Rather it is an example of how genius truly can fail when overconfident and floundering in the hazy, polluted and bloated detritus of hubris and pride. 

Through all of market history, there are countless examples of hubris leading to financial destruction. Inexplicably, the hubris returns as if shape shifting. Hubris doesn't die. It just fades away for a while, and then returns in another incarnation.

A recent example is that of Amaranth Advisers, LLC. In September 2006 it collapsed after losing roughly US$6 billion in a single week on natural gas futures trades. The failure was the largest hedge fund collapse in history. The head trader, Brian Hunter, continued to add to his losing position in natural gas futures using 8:1 leverage on spreads. The spread between the March and April 2007 contracts went from US$2.49 at the end of August 2006 to US$0.58 by the end of September 2006. The price decline was catastrophic for Amaranth, resulting in a loss of US$6.5 billion.

If even a tiny teardrop for the natural gas fiasco was shed, it was short lived and likely kissed away by his loving wife and children who were, no doubt, thrilled by the US$1.6 plus million that Hunter walked away with.

Like a Phoenix rising from the ashes of a natural gas disaster, Hunter is back with a new hedge fund and people are scrambling to get in. Hunter set out to launch his own commodities fund, Solengo Capital. It had no trouble attracting backers in early 2007. According to one estimate, Hunter raised US$800 million in startup capital, after putting up US$1.7 million of his own funds. 

That made sense to Christopher Holt, a Toronto-based finance consultant. “A number of people who invested with Hunter in the past may be very eager to get in again,” he explained to Reuters last March. “As ironic as it sounds, these people have had the chance to hear Hunter's explanation of what went wrong the last time and be assured that it won't happen again. The guys who come back from the dead actually have a pretty high success rate.”

I could go on and on with examples of hubris and arrogance, but the point of this piece is that behavioral biases are pervasive and sticky. They die hard, if at all. 

The concepts of hubris and overconfidence have critical implications for all investors and traders. 

Success in investing doesn't correlate with IQ once you're above the level of 25. Once you have ordinary intelligence, what you need is the temperament to control the urges that get other people into trouble in investing…Warren Buffett

Many studies have shown that human beings are almost universally irrational about money. The explanation lies in the human brain and its one quadrillion neuronal connections. For two million years, Homo sapiens has survived through herding behavior. They either fought or fled at the first sign of impending danger. These traits do not lend themselves well to successful trading. In contrast to two million years of Homo sapiens, modern finance theory has existed for only about 40 years. When placed on a 24-hour scale, that's less than two seconds. What have we learned in the past two seconds?

In and out of the markets, human beings make a litany of errors. Some of these are called cognitive biases . These include, but are not limited to herding, mental accounting, loss aversion, anchoring, reluctance to admit mistakes, confusing luck with skill and—the topic of this article—overconfidence.
Have you ever been guilty of any of these? I certainly have—and much to the detriment of my success in the markets and personal relationships! Generally speaking, confidence is a fabulous trait. It underpins motivation, persistence, energy and optimism, and allows us to accomplish things that we otherwise might not have undertaken. Confidence per se is not a bad thing; it helps to free us from analysis paralysis .

Such paralysis often results from information overload via 'round the clock financial infotainment networks or the homogenized and sanitized lame stream media. Confidence also relates to the inner state of happiness. There is a multibazillion-dollar industry of books, seminars, tapes and gurus built around inspiring people to be confident and keep pushing forward. Unfortunately, most of this does not work on a sustained basis. If it did, we would not have a situation where at least one in three people in the United States takes at least one mood-altering drug daily. 

With that said, confidence is not the issue here. It's overconfidence that gets traders and investors into really big messes. As a nation, we are truly, madly and deeply overconfident. In fact, sometimes we are on the verge of being delusionally overconfident. All one need do is watch tryouts for programs like American Idol or So You Think You Can Dance to see unfortunate and misguided overconfidence in action. 

And more examples: 82% of people say they are in the top 30% of safe drivers; Doctors consistently overestimate their ability to detect certain diseases (think about this the next time you wonder about whether to get a second medical opinion). Mutual fund managers, analysts, and business executives at a conference were asked to write down how much money they would have at retirement and how much the average person in the room would have. The average figures were $5 million and $2.6 million, respectively. The professor who asked the question said that, regardless of the audience, the ratio is always approximately 2:1. Overconfidence? Sounds like it for sure. We are walking a fine but critical line here. Note this quotation:

One of the most strikingly evident traits of all the market wizards is their high level of confidence….But the more interviews I do with market wizard types the more I become convinced that confidence is an inherent trait shared by these traders as much as a contributing factor to their success as a consequence of it. An honest self-appraisal in respect to confidence may be one of the best predictors of a trader's prospect for success in the markets…Jack Schwager, Market Wizards: Interviews with America's Top Stock Traders, 2002.

Importantly, it turns out that the more difficult the question/task (such as predicting the future of a company or the price of a stock), the greater the degree of overconfidence. In addition, professional investors—so-called experts—are generally more prone to overconfidence than novices because they have theories and models that they tend to over rate. When given a series of questions to test the degree of overconfidence, analysts, money managers and day traders score the highest levels of overconfidence. 

Perhaps more surprising than the degree of overconfidence itself is that overconfidence doesn't seem to decline over time. One would think that with experience and practice, people might become more realistic about their capabilities, especially in an area such as investing, where results are precise. As a general rule, they do not! Part of the explanation is that they often and conveniently forget failures and tend to focus primarily on the future, not the past or the present.

Neurobehaviorally, the main reason is that they generally remember failure very differently from how they recall success. Success is attributed to knowledge and skill, while failure is blamed on bad luck. Our brains trick us into believing that the outcome will be different next time. The trade that went bad was a result of circumstances outside of our control and had nothing to do with us. Something or someone else is always to blame. 

Overconfidence in financial decision-making is detrimental to the health of our portfolios in several ways: 

Overtrading . The brilliant work of Odean and Barber showed that investors who switch to online trading suffer significantly lower returns, and concluded "Trigger-happy investors are prone to shooting themselves in the foot."

Inflated estimates of the ability to pick stocks . Most people believe they are above-average stock pickers, when there is little evidence to support this belief. The work of Odean and Barber also showed that after trading costs (but before taxes) the average investor under-performed the market by approximately two percentage points per year. 

Continued attempts to time the market . Investors tend to trade in and out of mutual funds or ETF's at the worst possible time because they chase performance. From 1984 through 1995, the average stock mutual fund posted a yearly gain of 12.3% (versus 15.4% for the S&P 500). During this same period, the average investor in a stock mutual fund earned 6.3%. The bottom line is that, over 12 years, the typical mutual fund investor would have made nearly double the amount of money by simply buying and holding the average mutual fund and nearly three times as much by buying and holding an S&P 500 Index fund. With taxes factored in, the differences are astounding. 

So, what are some simple techniques that you can implement to begin the process of overcoming overconfidence?

• The first step to getting over yourself in terms of your own overconfidence is to admit it and accept it. This is part and parcel of the mantra of The Trading Doctor: “Trader Know Thyself!” Recognize that overconfidence is a form of self-sabotage, and take steps to begin understanding why you continue to undermine yourself by doing the same thing over and over again and expecting different results. 

• As part of the journey into authenticity and integrity as a trader, it is critical to know your own trading personality and the biases that keep you from moving forward. No matter how many fancy indicators, trading systems or guru newsletters you receive, it is not enough. All of the answers to trading success lie within you. The closest thing to the Holy Grail of trading is radical honesty with yourself about how your brain works under conditions of uncertainty.

• Among the best (and—for most traders the most difficult) ways to really get a handle on overconfidence is to keep a brutally honest trading journal. In order to get to where you want to be as a trader, it is necessary to look at your mistakes and learn from them. When you can see them in black and white, they are a guidepost for discovery. 

• Realize that trading success is about learning something new every day. You don't know it all and never will. No one does. Begin with the premise that no one knows anything. Study the lessons from market history and the great wipeouts and victories of large traders and hedge funds. Learn that there is no substitute for humility and gratitude when trading the markets. We don't know what we don't know and we don't know that we don't know it. All we can do is to learn to be comfortable with uncertainty and stay firmly in the realm of probability. 

Whosoever wishes to know about the world must learn about it in its particular details.
Knowledge is not intelligence.
In searching for the truth be ready for the unexpected.
Change alone is unchanging.
The same road goes both up and down.
The beginning of a circle is also its end.
Not I, but the world says it: all is one.
Yet everything comes in season… Heracleitus of Ephesos 

By Dr. Janice Dorn, MD, PhD
Prescriptions for Profits
www.thetradingdoctor.com

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© Copyright 2006-07 -- Janice Dorn, M.D., Ph.D. -- Ocean Ivory LLC

Dr. Janice Dorn is a graduate of the Albert Einstein College of Medicine, where she received her Ph.D. in Neuroanatomy. She did her postdoctoral work in Neurophysiology at the New York Medical College. She received her M.D. from La Universidad Autonoma de Ciudad Juarez, did one year of clinical clerkships in Phoenix, Arizona. and then completed a Neurology Internship at The University of New Mexico in Albuquerque. For the past twelve years, Dr. Dorn has focused her attention on trading, mentoring and commentary in the financial markets, with emphasis on Behavioral NeuroFinance, Mass NeuroPsychology, Trading NeuroPsychology, Futurism and Life Extension. A graduate of Coach University, she is a full time futures trader and trading coach.  Dr. Dorn is the author of over 300 publications, relating to Trading and Investing Neurouropsychology, Market Mass Neuropsychology, Behavioral Neurofinance, and Holistic Wellness and Longevity. 

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