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Investing: Don't fall in to an ego trap

October 15, 2007 11:05 IST
Mahesh Sharma was a sharp cookie in trading auto parts and was, till recently, living in an upscale apartment with the movers and shakers in South Mumbai. His usual brag would be ''so and so director lives in my complex''.

That bragging was further extended to his investment style as well, and one can easily notice he suffers from something commonly know as an ego trap.

However, the market has its unique way of humbling every person. And Mahesh also found it the hard way.

Overconfidence in financial terms is the tendency to think that you know way too much (or know it all) and place big bets based on that knowledge (or information). Generally, when you find initial success that reinforces your wisdom, then your overconfidence just increases and transforms into a big fat ego. 

Coming back to Sharma, in 1999 when technology stocks were the darling of investors, fund managers, brokers and analysts, even our friend jumped on to the bandwagon. He thought, "You can't go wrong with technology." His portfolio till then was well-diversified with a few concentrated stocks.

But suddenly, his entire portfolio only had technology stocks. I warned him initially of the risks that he was running by being in a single sector investor. But he continued in his path of glory. In the first three to four months, I could doubt his judgment as well because the returns on his portfolio were to the tune of over 20 per cent a month. Sometimes, even I was tempted to join in the gold rush. But then better sense prevailed.

Then he decided to take higher risks and exposed over 90 per cent of his portfolio in a single technology start-up. And then the market decided to take its revenge. In exactly six months he had lost his entire portfolio as the start-up stayed a start-up, albeit with some new fancy furniture from money raised from the likes of Sharma.

But it is not just someone like our protagonist but even superstar fund managers who were heavily into technology stocks, and found themselves left with dud stocks and net asset values down to Rs 3 or Rs 4 when the markets crashed in the early nineties. While Sharma has only himself to blame as he had a fat ego, one wonders how even the fund

managers, who are armed with all that brilliant research material, could be prone to such mistakes.

This is one trap that you must consistently overcome to be successful and remain that way. It is very common to deny one's own ego and believe that you are not afflicted with it.

But it could strike you anytime and keeping a constant vigil on oneself helps. As Terrance Odean and Brad Barber of University of California-Davis in their 1998 study had said, ''We argue that the well-documented tendency for human beings to be overconfident can best explain the high trading levels and the resulting poor performance of individual investors. Our central message is that trading is hazardous to your wealth.''

Here are a few clues on when you could be falling in such a trap. If you think:

a. You can time a stock or the market and consistently make money. Getting it once may be possible but that does not give you this Midas touch.

b. You have made a wise decision by buying an investment oriented life insurance policy despite someone telling you that a term plan is the way to go.

c. You can identify the next Infosys of the market but cannot easily explain the dud choices you have made.

d. You think you know best and do not need an advisor.

Confidence is very good in all walks of life and fuels success in your career. However on achieving success through confidence, one can easily go to the next level, which is overconfidence, and that lays down the roots of your failure. Now, Sharma lives in a modest apartment in Andheri and takes a train to Dalal Street. Life goes on.

The writer is director, My Financial Advisor.

Amar Pandit