Saving Yourself From Yourself

Teetering atop the tower of books on my desk are two I bet you're hearing a lot about right now, Dow 36,000 and, as if that weren't enough, Dow 40,000. Each is every bit as confident in its view of the future as another recent title deeper in the pile, Riding the Bear: How to Prosper in the Coming Bear Market.

Which market forecast is right? I don't know. But you'll probably help yourself more by focusing on this fact of human nature and investing: Most of us are overconfident about our abilities--and our overconfidence hurts our portfolios.

This dismaying reality is laid out in two other books coming out this season amid a lot less racket: Smart Money Decisions, by Northwestern University B-school professor Max H. Bazerman (John Wiley, $24.95), and Santa Clara University finance professor Hersh Shefrin's Beyond Greed and Fear (Harvard Business School, $39.95). "People obsess about their money," Bazerman says. "They just don't obsess about it all that well."

Although the authors address different audiences--Bazerman individuals, Shefrin their advisers--they are united in their conviction that people routinely make mistakes with their money because they overestimate their abilities. Overconfidence is a human trait extending beyond investing. For example, when researchers ask people to rate their skill as drivers, 65% to 80% say they're above average. The only group psychologists don't regularly find to be overconfident, Shefrin says, are the clinically depressed.

What does this have to do with your investments? "Confident people tend to be a little bit too bold," Shefrin says. "Investors just trade too much and, as a result, hurt themselves." We credit ourselves with winning picks, he adds, blame others for losers, and go on merrily believing we're smarter than we are. Sound like you? I know it sounds like me, so I went looking for ways to protect me from myself. Here are three lines of defense:

-- ANTARCTIC VIEW. Next time my mind locks on a trade I want to make, I'll first try turning the whole decision upside down. Some hedge-fund investors I know actively seek evidence to undercut their theory. If they were hot on Dell Computer, they'd go out and pump corporate buyers for reasons why they didn't like ordering from Dell. They'd even get them to badmouth the company. "If you're buying a stock," Bazerman suggests, "ask yourself why is it that someone else is selling it. Why do you think you know more than the seller? Force yourself to argue why you should sell the stock instead."

-- COLD EYE IN THE MIRROR. Seventeen years into this bull market, the old exercise for rookie investors called "paper trading"--fantasy stock-picking tracked with pencil and paper--seems quaint. Yet it's still the best way to safely calibrate our self-image against our true ability. "Keep a diary," Shefrin told me. "Enter predictions you make on how well the market will do over two weeks, four weeks, three months, six months, and a year. Do the same for the total returns of stocks in your portfolio. And also for any stocks you decided not to buy. Keep track of how well you do. It's quite sobering."

-- THE TRUTH ABOUT TORTOISES. The best defense against overconfidence may simply be to go slow--despite Wall Street's wisdom that the slow wind up as roadkill. Two finance professors at the University of California at Davis recently found that investors who switched to trading stocks by computer from the slower telephone method traded more often and more speculatively, with rotten results: With the phone, they beat the market by more than two percentage points a year. By computer, they wound up trailing the market by more than three points. "Trigger-happy traders are prone to shooting themselves in the foot," the profs, Brad Barber and Terrance Odean, concluded.

Dow 36,000, or Dow 6,000? I wish I knew. But knowing what I don't know may prove to be my smartest move.

Questions? Comments? E-mail or fax (407) 728-1711

Before it's here, it's on the Bloomberg Terminal.