Welcome back to our blog mini-series where I’m shining a light on nine of the basic investment mistakes people make. In this edition, I’ll focus on two mistakes that can be separate missteps but are often linked. They are Overconfidence and Speculation/Trading.
Overconfidence
Overconfidence is a state of mind where an investor believes their ability to pick stocks cannot be wrong. This often occurs in a stock market bubble and can result in the emotion of euphoria. I consider euphoria to be the opposite of panic. Euphoria enhances overconfidence to the extreme. It appeals to the human sense of greed.
Speculation/Trading
In the dot.com bubble of the late 90s, a big worry in stock investing was being outperformed by your brother-in- law. Dentists were selling their practices to day trade – a prime example of Speculation/Trading. Most investors thought the stock market (small companies and tech in particular) were going to grow excessively forever. Some of my clients were asking me to sell their large value companies and buy small company growth. The discipline of rebalancing has us doing the opposite. Which, as always, turned out to be the right thing to do.
Expert Insight and Lesson Learned
In an interview at the time, Warren Buffett was asked if he’d lost his touch. The Nasdaq was skyrocketing but his Berkshire Hathaway shares were in hibernation. Buffet replied, “A rising tide lifts all boats. Only when the tide goes out do you discover who is swimming naked.”
During booming times like we experienced in the 1990s, many investors were confident in their trading abilities. One young man I met told me of a small amount of funds he had after he graduated from college. He began trading stocks and options, against his father’s many objections. The young man grew his small amount substantially. When he lost it all, his father informed him that he had made it in ’93 and lost it in ’94. Dad took him down to the bank to borrow the money he needed to pay the capital gains taxes.
Cultural Influence
In the United States, new innovations from canal building for transportation to steam engines, cars, airplanes, television, and the internet have triggered these stock market bubbles. Human nature dictates this trend will continue as we continue to innovate. Who knows what the next trigger could be: AI, nanotechnology, gene editing, etc.
Furthermore, culture along with financial journalism is always pushing which stocks, sectors, or funds are red hot right now. This can influence an investor to make changes to their portfolio by selling the current laggard and buying the winner of the day. I assure you there is no better way to underperform than chasing returns. Whatever has been shooting the lights out over the last block of time has run its course and another will take off. Timing sectors can’t be done consistently.
Overconfidence resulting in euphoria and actions such as speculating are very destructive forces that can cause an individual more than just a failure to reach their goals. These mistakes have the power to destroy one’s entire financial life in a very short period of time.
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