Best of the Week
Most Popular
1. Gold vs Cash in a Financial Crisis - Richard_Mills
2.Current Stock Market Rally Similarities To 1999 - Chris_Vermeulen
3.America See You On The Dark Side Of The Moon - Part2 - James_Quinn
4.Stock Market Trend Forecast Outlook for 2020 - Nadeem_Walayat
5.Who Said Stock Market Traders and Investor are Emotional Right Now? - Chris_Vermeulen
6.Gold Upswing and Lessons from Gold Tops - P_Radomski_CFA
7.Economic Tribulation is Coming, and Here is Why - Michael_Pento
8.What to Expect in Our Next Recession/Depression? - Raymond_Matison
9.The Fed Celebrates While Americans Drown in Financial Despair - John_Mauldin
10.Hi-yo Silver Away! - Richard_Mills
Last 7 days
UK Coronavirus Infections and Deaths Trend Trajectory - Deviation Against Forecast - 1st Apr 20
Huge Unemployment Is Coming. Will It Push Gold Prices Up? - 1st Apr 20
Gold Powerful 2008 Lessons That Apply Today - 1st Apr 20
US Coronavirus Infections and Deaths Projections Trend Forecast - Video - 1st Apr 20
From Global Virus Acceleration to Global Debt Explosion - 1st Apr 20
UK Supermarkets Coronavirus Panic Buying Before Lock Down - Tesco Empty Shelves - 1st Apr 20
Gold From a Failed Breakout to a Failed Breakdown - 1st Apr 20
P FOR PANDEMIC - 1st Apr 20
The Past Stock Market Week Was More Important Than You May Understand - 31st Mar 20
Coronavirus - No, You Do Not Hear the Fat Lady Warming Up - 31st Mar 20
Life, Religions, Business, Globalization & Information Technology In The Post-Corona Pandemics Age - 31st Mar 20
Three Charts Every Stock Market Trader and Investor Must See - 31st Mar 20
Coronavirus Stocks Bear Market Trend Forecast - Video - 31st Mar 20
Coronavirus Dow Stocks Bear Market Into End April 2020 Trend Forecast - 31st Mar 20
Is it better to have a loan or credit card debt when applying for a mortgage? - 31st Mar 20
US and UK Coronavirus Trend Trajectories vs Bear Market and AI Stocks Sector - 30th Mar 20
Are Gold and Silver Mirroring 1999 to 2011 Again? - 30th Mar 20
Stock Market Next Cycle Low 7th April - 30th Mar 20
United States Coronavirus Infections and Deaths Trend Forecasts Into End April 2020 - 29th Mar 20
Some Positives in a Virus Wracked World - 29th Mar 20
Expert Tips to Save on Your Business’s Office Supply Purchases - 29th Mar 20
An Investment in Life - 29th Mar 20
Sheffield Coronavirus Pandemic Infections and Deaths Forecast - 29th Mar 20
UK Coronavirus Infections and Deaths Projections Trend Forecast - Video - 28th Mar 20
The Great Coronavirus Depression - Things Are Going to Change. Here’s What We Should Do - 28th Mar 20
One of the Biggest Stock Market Short Covering Rallies in History May Be Imminent - 28th Mar 20
The Fed, the Coronavirus and Investing - 28th Mar 20
Women’s Fashion Trends in the UK this 2020 - 28th Mar 20
The Last Minsky Financial Snowflake Has Fallen – What Now? - 28th Mar 20
UK Coronavirus Infections and Deaths Projections Trend Forecast Into End April 2020 - 28th Mar 20
DJIA Coronavirus Stock Market Technical Trend Analysis - 27th Mar 20
US and UK Case Fatality Rate Forecast for End April 2020 - 27th Mar 20
US Stock Market Upswing Meets Employment Data - 27th Mar 20
Will the Fed Going Nuclear Help the Economy and Gold? - 27th Mar 20
What you need to know about the impact of inflation - 27th Mar 20
CoronaVirus Herd Immunity, Flattening the Curve and Case Fatality Rate Analysis - 27th Mar 20
NHS Hospitals Before Coronavirus Tsunami Hits (Sheffield), STAY INDOORS FINAL WARNING! - 27th Mar 20
CoronaVirus Curve, Stock Market Crash, and Mortgage Massacre - 27th Mar 20
Finding an Expert Car Accident Lawyer - 27th Mar 20
We Are Facing a Depression, Not a Recession - 26th Mar 20
US Housing Real Estate Market Concern - 26th Mar 20
Covid-19 Pandemic Affecting Bitcoin - 26th Mar 20
Italy Coronavirus Case Fataility Rate and Infections Trend Analysis - 26th Mar 20
Why Is Online Gambling Becoming More Popular? - 26th Mar 20
Dark Pools of Capital Profiting from Coronavirus Stock Markets CRASH! - 26th Mar 20
CoronaVirus Herd Immunity and Flattening the Curve - 25th Mar 20
Coronavirus Lesson #1 for Investors: Beware Predictions of Stock Market Bottoms - 25th Mar 20
CoronaVirus Stock Market Trend Implications - 25th Mar 20
Pandemonium in Precious Metals Market as Fear Gives Way to Command Economy - 25th Mar 20
Pandemics and Gold - 25th Mar 20
UK Coronavirus Hotspots - Cities with Highest Risks of Getting Infected - 25th Mar 20
WARNING US Coronavirus Infections and Deaths Going Ballistic! - 24th Mar 20
Coronavirus Crisis - Weeks Where Decades Happen - 24th Mar 20
Industry Trends: Online Casinos & Online Slots Game Market Analysis - 24th Mar 20
Five Amazingly High-Tech Products Just on the Market that You Should Check Out - 24th Mar 20
UK Coronavirus WARNING - Infections Trend Trajectory Worse than Italy - 24th Mar 20
Rick Rule: 'A Different Phrase for Stocks Bear Market Is Sale' - 24th Mar 20
Stock Market Minor Cycle Bounce - 24th Mar 20
Gold’s century - While stocks dominated headlines, gold quietly performed - 24th Mar 20
Big Tech Is Now On The Offensive Against The Coronavirus - 24th Mar 20
Socialism at Its Finest after Fed’s Bazooka Fails - 24th Mar 20
Dark Pools of Capital Profiting from Coronavirus Stock and Financial Markets CRASH! - 23rd Mar 20
Will Trump’s Free Cash Help the Economy and Gold Market? - 23rd Mar 20
Coronavirus Clarifies Priorities - 23rd Mar 20
Could the Coronavirus Cause the Next ‘Arab Spring’? - 23rd Mar 20
Concerned About The US Real Estate Market? Us Too! - 23rd Mar 20
Gold Stocks Peak Bleak? - 22nd Mar 20
UK Supermarkets Coronavirus Panic Buying, Empty Tesco Shelves, Stock Piling, Hoarding Preppers - 22nd Mar 20
US Coronavirus Infections and Deaths Going Ballistic as Government Start to Ramp Up Testing - 21st Mar 20
Your Investment Portfolio for the Next Decade—Fix It with the “Anti-Stock” - 21st Mar 20
CORONA HOAX: This Is Almost Completely Contrived and Here’s Proof - 21st Mar 20
Gold-Silver Ratio Tops 100; Silver Headed For Sub-$10 - 21st Mar 20
Coronavirus - Don’t Ask, Don’t Test - 21st Mar 20
Napag and Napag Trading Best Petroleum & Crude Oil Company - 21st Mar 20
UK Coronavirus Infections Trend Trajectory Worse than Italy - Government PANICs! Sterling Crashes! - 20th Mar 20
UK Critical Care Nurse Cries at Empty SuperMarket Shelves, Coronavirus Panic Buying Stockpiling - 20th Mar 20
Coronavirus Is Not an Emergency. It’s a War - 20th Mar 20
Why You Should Invest in the $5 Gold Coin - 20th Mar 20
Four Key Stock Market Questions To This Coronavirus Crisis Everyone is Asking - 20th Mar 20
Gold to Silver Ratio’s Breakout – Like a Hot Knife Through Butter - 20th Mar 20
The Coronavirus Contraction - Only Cooperation Can Defeat Impending Global Crisis - 20th Mar 20
Is This What Peak Market Fear Looks Like? - 20th Mar 20
Alessandro De Dorides - Business Consultant - 20th Mar 20
Why a Second Depression is Possible but Not Likely - 20th Mar 20

Market Oracle FREE Newsletter

Coronavirus-bear-market-2020-analysis

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

Signup for your risk-free subscription to the Trading Doctor Newsletter. If you are not completely satisfied that our newsletter is for you just let us know, via email, within 7 days of your subscription date and we'll immediatly refund your money.

© 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. 

Dr. Janice Dorn Archive

© 2005-2019 http://www.MarketOracle.co.uk - The Market Oracle is a FREE Daily Financial Markets Analysis & Forecasting online publication.


Post Comment

Only logged in users are allowed to post comments. Register/ Log in

6 Critical Money Making Rules