The Path Between Fear and Overconfidence

A lot of investing mistakes can be summed up to one of two things: Overconfidence or Fear. And, despite the fact that these are two sides of the same spectrum, an individual can fall prey to both of them from time to time. In many ways, that’s what the stock market is all about.

Overconfidence

Many investors make the mistake of being too sure of themselves. Overconfidence and exuberance cause bubbles and lose fortunes. This is arguably a huge factor in the cause of this whole global financial crisis. A combination of greed and a sense of not-possibly-being-able-to-do-wrong is what caused once well-respected institutions to collapse. There’s simply no other explanation for the type of leverage that some institutions took on. How can any reasonable collection of individuals set up an investment strategy that completely collapses if it drops by a few percent?

Worse yet, our minds are hardwired for overconfidence. A gambler finds it easier to recall their big wins than their several losses, even if their losses dramatically outweigh their wins. The same can be true for the stock market, especially since for the way that many people approach it, it is gambling.

Most people consider their self to be above average. By definition, only half of people can be above average drivers, possess above average intelligence, or have above average morality, and yet far more than half consider their self to be these things. The same is true for investing: most consider themselves somehow better. I’d wager that such a feeling is hardwired into us for survival, but an investor must take control of it.

Fear

On the other side of the spectrum, fear can cause problems too. As soon as things turn sour, people have a habit of running for the hills and assuming that it’s never going to get any better. It’s not uncommon for a high-quality company to sometimes develop a hefty amount of bad press for one or more things, and then to find that its stock valuation has dropped dramatically. The media needs something to do everyday, and something to scare you with.

Bad press is often legitimate. Large companies do some pretty silly things sometimes, and there are certainly red flags and other warning signs to be aware of. But good companies are built to last through tough times. Bad news is a reasonable cause of a mild stock drop, but usually the market overreacts with fear. When a company is experiencing problems, people seem to expect that these problems will be permanent and that the company is no longer of any use.

Worse yet, fear is sometimes triggered by literally no reason at all. Sometimes stock sell-offs occur seemingly out of the blue, for reasons not related at all to company performance. Fearful investors freak out at their falling paper net worth and they sell sell sell!

The Path

The combination of overconfidence and fear is what causes stock market graphs to look ridiculous. A calm and patient investor, however, uses the absurdity of the market to his or her advantage, by consistently buying high-quality companies at good prices and ignoring short-term market noise.

There’s no silver bullet for developing a successful investor’s mindset, and it can take many mistakes and plenty of experience to learn, but there are some timeless guidelines:

-When you make an investment, write down your investment thesis and save it. When things become questionable, you’ll be glad you have a tangible declaration of why you purchased the stock in the first place and this will allow you to make a more measured decision on what to do.

-Focus on passive income, and the psychological edge that dividends can provide. Dividends provide a huge sense of normalcy and reason in the stock market. They’re declared by the board of directors based on company performance rather than determined by the whims of the market. By focusing on building sustainable and growing dividend income streams, investors should find most of these psychological obstacles of fear and overconfidence removed from their way.

-Focus on company fundamentals. Ignore the stock market and focus on how the company is actually doing. Is the revenue increasing? And earnings and cash flow? Is the payout ratio reasonable, and is the dividend well-covered by cash flow? What are the debt levels like? Are the products and services provided by this company going to be in demand 3, 5, and 10 years from now? Are they growing their number of facilities/locations/volumes? If the company has some bad news, how bad is it? If the stock price got cut in half recently, is it because the company actually made a mistake big enough to cut its company value in half, or did it just spook speculators and institutions with a small misstep?

-Always keep the valuation in mind. You’re buying a business rather than just a stock. It doesn’t matter whether you’re a value investor or a growth investor; the valuation is important. This doesn’t mean to specifically buy cheap stocks or to avoid high P/E stocks, but it does mean to weigh the prospects of the company against its stock price, and determine what kind of company performance would be necessary to justify the current price of the stock. Looking back at the dot com bubble, there was simply no way to justify the stock prices of many companies. Impossible levels of growth would have been necessary.

-Utilize a margin of safety. Once you’ve compared prospective company performance to the current stock price, make sure you leave yourself a margin of safety. To put it simply, our estimations are going to be wrong sometimes, so keep that in mind and focus on buying companies when their shares are cheaper than what you think they are worth. This way, many of your mild mistakes will still be victories.

-Diversify your assets. Invest in several stocks to keep your risks related to any single stock relatively low. Keep some money out of equities so that you can take advantage of undervalued markets when the opportunity arises, either by means of automatic asset allocation or through individual stock-picking.

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Comments

  1. Great post, I agree with every word. As Warren Buffett put it:
    “Investors should remember that excitement and expenses are their enemies. And if they insist on trying to time their participation in equities, they should try to be fearful when others are greedy and greedy when others are fearful. ”

    I think its vital to keep a framework to follow. Pick a strategy that you feel secure with and stick with it.

    I agree that dividendinvesting gives confidence when the market collapses. Dividendyield will skyrocket with a market downturn. We should see market downturns as an opportunity to buy quality companies at a sale. Market downturns usually exaggerate, essentially you can buy the same companies as before the crisis at a discount.

    I kind off like the market to be depressed and going down, this way I can keep buying quality dividend companies cheap. If it keeps undervaluing companies, then fine I still get my high growing dividend yields at low risk.

    When the market becomes positive again the buying opportunities get fewer and the risks increase. This view of bearmarket as a positive thing for the patient investor is certainly not shared by the market.

  2. Most of my investing mistakes were a result of these two. One I remember the best was when I bought shares of Citigroup. The stuff was hanging around the three dollar range and then started shooting upwards. I thought holy crap I’m gonna miss it so I jumped in around $5.00 a share. Shortly after that it fell back down…..way back down. I was afraid I was gonna miss a big run up in the stock and was overconfident that it would keep going up. It seems when things are going up it feels like they will go up forever so we make bad decisions based on our overconfidence.
    In case you’re wondering, I used the new lower price to buy a lot more shares to lower my basis close to where the stock is at today.

  3. This is a great reminder. I find with my short term positions that I border on gambling and really need to keep that in check.

    Thanks for the Great post Monk!

  4. Defensiven,

    Very good point. People that are net-buyers of the stock market should be happy about a falling market and disappointed about a rising market. Of course they should want good economic activity, but that unfortunately often goes hand-in-hand with high stock market valuations.

  5. Matt,

    Thanks so much for writing about utilizing a margin of safety. This is an excellent strategy and reading your post made me realize that it’s a really good principle.

    I often assume my estimations of valuation are incorrect and wait to see if a stock drops even more before purchasing shares. Unfortunately, many times this means I’ll miss out on buying shares when the valuation was actually correct, but I don’t worry about this, since there are always opportunities in the market. Though I sometimes miss out on a great chance to buy a great stock at a good price, like you pointed out, my mild mistakes are more likely to become victories so it doesn’t worry me.

    I always try to remind myself that it’s better to be on the sidelines, wishing you had bought a stock than be a shareholder watching the equity come crashing back to reality.

  6. Matt,

    Great stuff man. I really enjoyed how you wrote about both ends of the spectrum.
    Where do you lie? Do you find yourself at one end or the other most times? I know I go between the two now and again, although I might not be as seasoned investor as you in order to be more confident (not overly) vs. fearful :)

    To me, and this might sound weird, I focus little on the stock price. It’s just that, a price. I tend to focus on the business and its products or services, in a general sense. Stock price IMO has very little to do with revenues, dividend payout ratios and the prospects of the business. If the business is sound; price really doesn’t matter to me. It becomes somewhat superficial.

    Cheers,
    Mark @ My Own Advisor

  7. Hi Pey,

    Thanks for the comment. It sounds like you’re doing a particularly good job of following Buffett’s first two rules. (1. Never lose money. 2. Don’t forget rule #1)

    Mark,

    Good question. I’d say I am somewhere closer to the overconfidence side if I had to classify myself. Like you, I don’t focus much on the price, except for using it to determine whether the stock is currently attractively valued or not. If business fundamentals of a company remain good, but stock price decreases, I actually prefer that because it allows me opportunities to make attractively priced investments.

    When I was learning to invest, I made some fear-related mistakes. I’m sure I still do by missing opportunities. Right now, Microsoft looks attractively priced to me but I’m sitting on the sidelines because I’m a little bit spooked by the long-term fundamentals of the business.

  8. Buffetts first two rules are solid! I would definately say im more on the fear side. Like all the time. Either its the high prices that worry me or the weak economy.

    When i first started investing i was more opportunistic, only looking on the companies line of business and “stockactivity”. Today I am much more defensive and focus on the fundamentals and valuation. I follow a narrow framework for stock selection, for example my demands on financial strength are a bit extreme as they exclude most industry companies.

    Defensivens take on risktaking:
    “When it comes to risk, Id rather be paranoid then oblivious ” :)

  9. Very nice article DM,

    Fear is the smallest of my problems, any time i take a position is following a list of fundamental reasons that consist of the basis for my position. I have an excel sheet that is always at hand to remind me why i invested in a stock and inform me who is the next target to follow. buying on triple digit loss days are my favorite days!

    However, human nature can intervene at any moment and undermine the plan. I will always keep both feet firmly grounded, overconfidence precedes the fall! In the market its important to remember that prices go up and down and sometimes there is bound to be losses.

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