We Do It to Ourselves

I'm not a pessimist, just a professional obsessive-compulsive. While investors must be confident in order to take a risk, they must also be realistic enough to know they're often dead wrong. To that end, I've developed a few small tricks to help battle the natural tendency toward overconfidence.

While due diligence is important, there's nothing to be gained from setting price targets, a meaningless exercise still practiced by pros and novices alike. You know the drill. With XYZ at $25, the Armani-suited analyst issues a Strong Buy, suggesting that the stock could eventually hit $40. The herd snaps it up, placing sell orders up at $40 and eagerly waiting for the profits to pour in. If only it were that easy.

The problem with price targets is that they keep investors focused on exactly the wrong thing. While they enter every trade with the expectation that it will be a winner, very few turn out to be so. Setting a price target prompts the expectation of gain rather than the potential for loss. Investors think about how high it can go, not how far it can fall. Of course, a stock can go to zero — and many do.

Perhaps more harmful: Setting price targets mistakenly prompts investors to think of stocks as "high" or "low" rather than strong or weak. So if they buy XYZ at $10, and it eventually reaches their price target of $15, they sell. They've made money; the stock is now "high" relative to where they bought it, so why not take a profit? Yet it's the arbitrary price target that clouds judgment. The stock doesn't know where a particular investor got in, and while he's bailing at $15, the stock is on its way past $20.

Real-world examples of this scenario abound. Can you imagine how many investors bought Microsoft (MSFT) back in 1990 at a split-adjusted $1/share, only to sell it at $2 once their price target had been achieved? (It eventually climbed to $60.) Moreover, oftentimes, by the time a price target has been reached, the fundamental reasons the investor set it in the first place have changed.

So instead of setting price targets, I focus on loss limits. I enter every trade with a concrete price at which I'll get out — on the downside. Regardless of whether it's a drop of 10%, 15% or 20%, what matters most about a discipline is simply having one in the first place. Because I've already anticipated the possibility that the trade could fizzle, it becomes a lot easier to actually pull the trigger should that unfortunate reality come to pass.

Just as investors are overconfident about how a particular investment might turn out, the same instinct can prompt overly optimistic expectations for everything from expenses to inflation. In the real world, most things tend to be more expensive and time consuming than one would initially believe. And because the best-laid plans can go horribly awry, whenever I make estimates — about markets, costs or returns — I like to err decidedly on the conservative side.

For example, during the late 1990s, many financial planners routinely used 13% or 15% as their estimates for annual stock-market returns. Why not? With the S&P 500 soaring year after year, it seemed like a perfectly reasonable expectation at the time. Of course, once the bear market hit, many investors, especially retirees, were badly burned as the market drastically underperformed. Instead of the 10% to 15% most planners use, I like to use 6% to 9% as a more realistic expectation of long-term returns on stocks.

The same approach goes for inflation. Inflation might be quiet, but it's far from dead. At some point in the next few years, we'll likely be surprised about how quickly it comes roaring back. So while 2% is often used as an estimate of future inflation, when using tools such as Smartmoney's Asset Allocator I like to plug in 3% or even 4% when calculating the future purchasing power of savings.

(Almost every element of fiscal responsibility can be skewed a bit toward a more prudent approach. While most financial planners recommend putting three months' worth of living expenses into an "emergency fund," I opt for nine months (or more). Instead of paying the minimum balance on a credit card, I eliminate the entire debt — and then some. If I owe Visa $1,000, I'll send them a check for $1,100, knowing that whatever the inevitable expense will be, I've "paid it forward" at least by a small amount.)

Finally, overconfidence can hurt investors mostly when it comes to position size, exactly the place where trading technique falls by the wayside. As I always point out, you can make a bullish argument for any investment under the sun. Yet the more you believe in a trade, the larger position you're prone to take. This can be disastrous should the market not perform as you expect. And when does it ever?

Say it with me: Size kills. Want to buy Merck (MRK), or Lucent (LU), or any other former growth stock past its prime? Knock yourself out. But to put more than 2% to 3% of your portfolio into an initial position is simply asking for trouble, no matter how much you believe the trade will work out.

And while I have nothing against being aggressive, as I wrote a few years back, positions should grow large — they shouldn't start out that way. One of the most important elements of trading technique is maintaining consistent position sizes for new stocks. By picking a trading "unit" — say, 2% of your portfolio — assets are allocated objectively, rather than counting on your gut to feel how much risk to take.

It prevents the all-too-common occurrence when a "risky" stock receives only a tiny allocation, while you bet the farm on the "safe" one about which you are overconfident. What inevitably happens, and I've seen this time and time again, is that the "risky" stock leaps higher while the "safe" one underperforms. You end up losing money overall because of an inordinately large position in what you believed to be a sure thing.

Jonathan Hoenig is managing member at Capitalistpig Hedge Fund LLC.