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A Time For Optimism, But Not Overconfidence

Posted: Mon Oct 23, 2006 4:22 pm
I really liked this articel of guys from Inneworth and would like to share it:

There is a sense of excitement in the markets these days: Highs above 12,000, profitable earnings reports, stocks on the move. All these signs show the world that the stock market is doing well, and as a trader, you should be ready to capitalize on the enthusiasm. You have to ask yourself, however, am I going to be a wise, profitable investor or one of the naïve masses that ends up giving back more than I made?

With all the excitement, it's easy to get caught up in thinking only about short-term gains. Why not push yourself to the edge and trade with wild abandon? You might make a few big wins, but the long-term profitable trader looks at the big picture. Behavioral economists have two pieces of advice during record breaking bullish markets where high probability setups seem abundant: Don't let overconfidence get the better of you and treat windfalls with respect. Finance professors Brad Barber and Terrance Odean analyzed account records from a large sample of online investors. They identified a subgroup as "overconfident" in that they had a substantial initial success at the start of the study, but ended up with lower account balances at the end of the study compared to less confident investors. The overconfident investors put on substantially more trades than other investors, yet achieved few rewards for their efforts. Optimism isn't all bad, but it's probably not a good idea to be optimistic to the point of putting on trades without thinking through all the consequences, and carefully managing risk, such as limiting the size of a position or using protective stops. During optimistic times, though, it's tempting to believe that potential profits are unlimited and that to make a once-in-a-lifetime trade, you should abandon all risk limits and take huge risks. For some people and under the right circumstances, such a strategy can pay off big, but more often than not, many traders who abandon risk limits end up with nothing more than mountains of regret.

During optimistic times, you may also fall for the windfall bias. Suppose you devise a trading plan to take advantage of those earnings reports. Perhaps you anticipated that the earnings report would lead to a stock price increase and got in and out at the right time. What do you do with your profits? Many traders view such profits as a windfall and tend to trade this new found wealth recklessly. A study by Dr. Hal Arkes and colleagues at Ohio University, for example, illustrates how people tend to spend windfalls freely. People were unexpectedly given a windfall of $5 right before attending a basketball game. They spent twice as much money as people who didn't receive a windfall. When people receive windfalls, they tend to think, "easy come, easy go." As tempting as it may be to treat windfalls as easy money, though, don't forget that profits are profits. It is vital to treat profits equally, regardless of how easy they were accumulated. When trading the markets, how well you do across a series of trades is tantamount. You can't throw out discipline just because the market is reaching new highs. Your long-term survival depends on carefully managing your capital. Don't feel that you can take bigger risks with capital that was easy to come by. Capital is capital, and if you manage it prudently, you will make significant gains that you can keep well after market conditions change.