reliance on stereotypes of enemies, and an ignorance of or inabil-ity to develop new tactics. Famous examples of victory disease includethe failure of the imperial Japanese navy to set up a defensive perimeter
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following their initial string of victories in World War II and Napoleon’sill-fated invasion of Russia.
Nobel Prize disease is a notable form of intellectual decay among No-bel Prize winners. Economist Paul Samuelson described the symptoms ofthe “disease” among afﬂicted Nobel laureates: “After winners receive theaward and adulation, they wither away into vainglorious sterility. Morethan that, they become pontiﬁcating windbags, preaching to the world onethics and futurology, politics and philosophy. At circular tables, wherethey sit they believe to be the head of the table.”1
Directly related to investors’ concerns, the business press has coinedthe term CEO disease to refer to the tendency of CEOs to underperformafter achieving the top position in their organization.2 All three afﬂictions(victory disease, Nobel Prize disease, and CEO disease) follow a similarpsychological pattern. The remainder of this chapter will discuss the psy-chology and neuroscience underlying the investor biases of overconﬁdenceand hubris.
THE PSYCHOLOGY OF HUBRIS
“Meriwether and his sidekicks had a bad case ofhubris. As Kaufman puts it: “There are two kindsof people who lose money: those who know noth-ing and those who know everything.” With two No-bel Prize winners in the house, Long-Term Capitalclearly ﬁts the second case.”
—R. Lenzner3
My medical school senior project involved researching the psycholog-ical origins of ﬁnancial risk taking and asset bubbles. This was timely re-search, begun in January 2000, and inspired by my amazement with theInternet stock bubble. At the time, I read a book by David Dreman enti-tled Psychology and the Stock Market, which was ﬁrst published in 1977.Dreman describes a speculative mania in “-onics” stocks in the early 1960sduring which short-term traders called gunslingers made and lost fortunes:“The more esoteric the concept, the better the public liked it. Any companyending in ‘-onics’ was almost guaranteed an enthusiastic reception.”4 I feltlike I was reading the script for the Internet bubble, with .com and daytraders substituting for -onics and gunslingers.
I became intensely interested in the fact that Internet stocks wereclearly experiencing a bubble, yet investors continued to recklessly pourmoney in—as if they were conﬁdently counting on a bigger fool to buy their
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shares at a higher price sometime in the future. In my mind, there seemedno better example of hubris.
The English word hubris is derived from the Greek word hybris. Itrefers to the excessive pride that usually precedes the downfall of the tragichero in Greek drama. Hubris is found among successful individuals whosee external goals as their primary metric of success. Anywhere acclaimis awarded according to some extrinsic metric, such as wealth, beauty, orathletic prowess, achievers are vulnerable. Hubris is one of the most dan-gerous emotional states that investors can experience, as it often precedesthe greatest losses.
The ﬁrst stage of hubris is to have a series of gains or acclaim. If thosegains are attributed to one’s unique talents, skills, or intelligence, then theycan contribute to a persistent pattern of overconﬁdence. For overconﬁdentinvestors, risks are ignored and their belief in themselves is hypertrophied.
OVERCONFIDENCE
“According to a . . . Washington Post poll, . . . 94 per-cent of Americans said they are “above average”in honesty, 89 percent “above average” in commonsense, 86 percent “above average” in intelligence,and 79 percent “above average” in looks.”
—Chuck Shepherd, News of the Weird, 2006
In the United States, the cultivation of self-conﬁdence is widespread.Conﬁdence is thought to be so important that schools design curricula tosupport children’s self-esteem. And for the most part, conﬁdence is a goodthing. Without self-conﬁdence, people wouldn’t undertake challenging orrisky endeavors.
The problem with conﬁdence is so-called overconﬁdence. As seen inthe quote that opens this section, a majority of people are overconﬁdent. Inmany domains, belief in one’s capabilities creates a self-fulﬁlling prophecyof success. Yet in the ﬁnancial markets, overconﬁdence seriously impairsperformance. High levels of overconﬁdence and the illusion of controlhave been correlated with subpar performance among subjects in tradingexperiments.5,6
When queried, a majority of people report that they are above averagedrivers, lovers, athletes, and investors. Yet how can such a large majorityof people be above average? Clearly, somebody is overestimating his or hertalents.
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Some people are biologically predisposed to be overconﬁdent (espe-
cially, for example, young men). Others learn to be overconﬁdent.
There are several varieties of what is generally referred to as over-conﬁdence. One type of overconﬁdence is the “better-than-average” ef-fect. Researchers who ask subjects to rate their abilities, such as skillin driving, athletic ability, or running a business, ﬁnd that most peopleconsider themselves better than average.7 All humans overestimate theirabilities—depending on the study, between 65 and 80 percent believe theyare above-average drivers. In fact, 9 out of 10 males report the belief thattheir penises are longer than average.
Another type of overconﬁdence is called miscalibration. Some indi-viduals overestimate the precision of their knowledge and tend to use con-ﬁdence intervals that are too narrow.8 If a CEO is asked to provide an esti-mated range for his company’s annual earnings, the 90 percent conﬁdenceinterval is the range into which the actual value should fall 9 out of 10 times.The typical miscalibrated CEO would give too narrow an earnings range,with the actual earnings number frequently falling outside his 90 percentconﬁdence interval.
In one multiyear survey, chief ﬁnancial ofﬁcers (CFOs) were asked togive their 80 percent conﬁdence intervals for the stock market close overthe next year. When over 4,300 forecasts were measured against the ac-tual stock market performance, only 30.5 percent were accurate within theCFOs’ 80 percent conﬁdence intervals.9 One might hope that CFOs wouldhave a better sense of their limitations in ﬁnancial forecasting.
A third type of overconﬁdence involves one’s belief of control overrandom, independent events—called the illusion of control. Many peopleerroneously believe that they can control, predict, or somehow inﬂuencerandom events. The following experiment elicited the illusion of control.
In a (rigged) coin-tossing experiment subjects were asked to predictthe outcome of a coin toss. The experimenters ensured that each partici-pant would successfully “predict” exactly 15 of the 30 coin tosses (50 per-cent total accuracy).10 The experiment was further rigged so that one-thirdof the subjects were correct on their ﬁrst four predictions, one-third wereincorrect on four of the ﬁrst ﬁve coin ﬂips, and one-third had a randompattern of success.
After all the subjects had completed the experiment, they were askedto retrospectively estimate their accuracy. The one-third of participantswho began with four of ﬁve wins rated their overall accuracy signiﬁcantlybetter than the other participants. When asked how they would do in pre-dicting 100 further coin ﬂips, those who started with a series of wins ex-pected to make signiﬁcantly better predictions in subsequent games. Al-together, 40 percent of the players believed that their performance would
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improve with practice (even though they intellectually knew that the cointosses were random).11 The authors concluded that “An early, fairly con-sistent pattern of successes leads to skill attribution, which in turn leadssubjects to expect future successes.”12
One’s conﬁdence in his or her ability to predict the outcome of a gam-ble is stoked by a series of early wins. In a bull market, almost everyonewins. Amateurs who start investing during a bull market quickly come tobelieve that they have a special talent or skill at stock picking. An old WallStreet adage notes, “Everyone’s a genius in a bull market.” Early winnersare more likely to continue buying stocks as the market turns sour, sinceearly on they learned to believe in their investing genius.
Overconﬁdence actually changes how people remember. Individuals’memories of prior events are biased to support their current overconﬁ-dence. There is a hardwired tendency for individuals to preferentially re-member their wins over their losses. What’s more, most people “misre-member their own predictions so as to exaggerate in hindsight what theyknew in foresight.”13
There is also a tendency to blame negative outcomes on uncontrollablecircumstances and to take credit for positive outcomes as a result of one’sforesight and expertise. Too often, people attribute success to their ownjudgment (and expert predictive ability) and loss to external forces beyondanyone’s capacity to forecast.14
Experts are particularly susceptible to overconﬁdence. Possibly dueto pressure from the social consensus that they have more knowledgeand skill than others, experts trust their own judgment more highly thanthey should. Overconﬁdent decision making has been found to be aconsistent pattern among ﬁnancial experts and professionals, includingentrepreneurs,15 investment bankers,16 executives, and managers.17,18
There are conditions in which overconﬁdence is rapidly extinguished,such as during decision-making tasks where (1) predictability is high, (2)swift and precise feedback about the accuracy of the judgments is pro-vided, and (3) tasks are highly repetitive.19 “Correspondingly, expert bridgeplayers, race-track bettors, and meteorologists were found to be well-calibrated in their predictions.”20
The ﬁnancial markets are characterized by unstable payoffs (pre-dictability is low) and often require a dynamic frequency of transactions(sometimes high activity, sometimes quiet). For traders, swift and precisefeedback is provided, yet this feedback is unstable and depends on marketconditions. Investors receive much less frequent feedback. As such, over-conﬁdence is a particularly acute problem among investors. In general, in-vestors who are overconﬁdent believe they can obtain large returns; thus,they trade often and they underestimate the associated risks.
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ILLUSION OF CONTROL
What conditions provoke investor overconﬁdence? In the above study, itwas clear that an early series of wins leads to overconﬁdence. In the studythat follows, subjects were found to be overconﬁdent if they had more con-trol over the decision-making process. Subjects were either given a lotteryticket with random numbers or allowed to choose their own numbers. Af-ter receiving their ticket, they were then offered a trade for a lottery ticketwith better odds. People who had chosen their own numbers preferred tokeep their tickets more often than those who had been given a randomticket. Those who chose their own numbers wanted an average $9 to givethe ticket up. Those who were randomly assigned a lottery ticket wantedonly $2. Based on this result, the experimenters argued that familiarity andchoice lead to an illusion of control.21
Other researchers found that the illusion of control is actually an over-conﬁdence in one’s predictive abilities, not a belief that one can control theoutcome. People are more attached to, and value more highly, their per-sonal prognostications and stock picks. In general, researchers have foundthat the illusion of control is more likely when:
Ĺ Many choices are available.Ĺ One has early success at a task.Ĺ The task one is undertaking is familiar.Ĺ The amount of information available is high.Ĺ One has personal stake in the outcome of the choice.Ĺ One has more control over the decision process.22
WINNING CHANGES THE BRAIN
Overconﬁdence may arise as a result of learning that one is performingwell. In functional magnetic resonance imaging (fMRI) studies, Brian Knut-son found that winning money activates the MPFC. The MPFC is at the ter-minus of the dopamine pathways of the reward system, and it is associatedwith both positive feelings and reward learning. In particular, activation ofthe MPFC signals that a reward pursuit action was successfully completed.When the MPFC is activated, it represents a signal that one is on tracktoward desired goals. When an action has yielded large rewards consis-tently, to the point of satiation, then one can shift his or her cognitive re-sources elsewhere. Soon, the risky activity will be undertaken with littleattention paid to potential dangers.
The MPFC is activated by many types of reward besides money. For ex-ample, seeing a favorite product (such as a favored brand of coffee, beer,
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FIGURE 8.1 Coronal and axial views of the medial prefrontal cortex (MPFC) aftersubjects received a monetary reward.
or soda) activates the MPFC. This brand-based activation indicates satis-faction with the product. Trusted others also activate the MPFC to someextent. Injections with cocaine and amphetamines activate the MPFC, sug-gesting a mechanism for the positive feelings associated with these drugs.The MPFC may be where drug addicts have learned to associate drug usewith pleasure. This same brain region is associated with reward learning,such that ﬁnancial success may lead to less motivation in reward pursuitand a stronger attachment to the status quo. Figure 8.1 depicts the MPFCjust after subjects received monetary rewards.
For many people, there is an internal success thermostat. That is, wheninvestors achieve their ﬁnancial goals, then their motivation drops off. Peo-ple need challenge to prosper, and when victorious at one activity repeat-edly, the novelty wears off and complacency sets in. As a result of thiscomplacency, risks are disregarded, and losses may suddenly ensue.
A very successful trader I met mentioned that he has a “proﬁt ceiling”that inhibits his success beyond his internal set point. He said that he hasall the money he will ever need, he gives lavishly to charities, and the onlyreason he continues to trade is to achieve his personal expected annualreturn. Beyond that internal benchmark, he is unmotivated.
This lack of motivation caused some stress in his life. If he didn’t tradeafter he achieved his goal in June, then what was he to do for the rest ofthe year? Often, he would trade poorly, churning his account until the newyear. When trading out of obligation and boredom, he reported occasion-ally forcing trades that he didn’t have his heart in—too often with negativeoutcomes. To combat the boredom, he appealed to his competitive nature,setting personal benchmarks and challenging himself to meet them afterhis primary goal had been achieved.
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THE NEUROCHEMISTRY OF EXPLORATION
How people approach challenges depends on their personal neurochem-istry. Individuals either (1) set about exploring their environment or (2)pause to take advantage of an opportunity. Whether they do (1) or (2) de-pends on their neurochemical balance.
As seen in the examples above, when a reward is found, dopamine neu-rons reinforce the reward-producing behavior. Dopamine neurons modifythe strength of the signals that led to the reward-obtaining behavior (usu-ally by increasing signaling to the MPFC). This is a process of reward learn-ing via the dopamine pathway.
If a behavior is no longer rewarding,
then norepinephrine lev-els increase in the brain. Norepinephrine stimulates scanning for newopportunities.23 Norepinephrine, a chief neurotransmitter responsible forvigilance and attention,induces people to explore their environmentand shift their attention frequently. Higher (but not excessive) nore-pinephrine activity causes increased vigilance and improved focus.24 Someof the newest medications to treat attention deﬁcit–hyperactivity disorder(ADHD) act exclusively on norepinephrine receptors (e.g., atomoxetine, anorepinephrine reuptake inhibitor).
When investors are extraordinarily proﬁtable for a year or two, theybegin to feel conﬁdent that they can continue to perform highly. Theirdopamine-based reward learning process encodes a proﬁtable pattern ofbehavior. Subsequently, however, highly proﬁtable traders may have dif-ﬁculty maintaining the same level of attention to risk management be-cause of a chemical shift in their brains. They become slightly bored andpush the limits of their abilities (and risk exposure in order to continue tofeel challenged. The combination of low relative dopamine levels duringtrading (because they have already learned proﬁtable techniques) and el-evated norepinephrine levels provokes increased boredom, distractibility,and scanning for new opportunities.
ONE WHO KNOWS: CHRISTIAN SIVA-JOTHY
Christian Siva-Jothy was formerly one of the biggest proprietary traderson Wall Street. While head of proprietary trading at Goldman Sachs, “histrades, the size of his bets, the consistency of his annual proﬁts for thebank, and his grace under pressure had become the stuff of legend amongtraders.”25
In 1994, while at Goldman Sachs, Siva-Jothy was under pressure tobeat his performance from 1993, during which he had earned $100 million
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for the ﬁrm through currency and derivative trading; 1992 had also beenan excellent year, and as a result, “I’d been on a bit of a roll and got car-ried away with it.” As Siva-Jothy explains, “I was a bit full of myself. . . .”Going into 1994, Siva-Jothy had built up a large long yen position. By earlyFebruary, his position was up $40 million. As his proﬁts grew, “People werestarting to say, ‘Christian is going to do it again.’ ”26
During the ﬁrst weekend in February 1994, Bill Clinton verbally as-saulted Japanese trade policy. As a result, the yen sold off and Siva-Jothy’spositions began to unwind. “I was selling out of the position as fast as Icould, but I was selling just to stand still because I was short these puts. Itwas a disaster. Markets have a way of taking it out of you.”27
Goldman lost between $100 and $200 million as a result of the trade.But Siva-Jothy didn’t emotionally collapse, “On day eight of this episode,when the biggest move happened and I lost about $40 million in one day,I remember this overwhelming desire to get up and walk out, to pretend itwasn’t happening. It was such a powerful emotion. Instead of walking out,though, I took a deep breath and liquidated everything.”28
Instead of yielding to a powerful denial urge, Siva-Jothy executed thenecessary trades. In strongly emotional situations, our cognitive “defenses”can be our worst enemies. Honing the courage to face one’s powerful emo-tions requires practice and inner strength.
When hedge fund consultant Steven Drobny asked Siva-Jothy what helearned from his 1994 loss, he replied, “Conﬁdence is a very, very danger-ous thing. Simply because you’ve had a good run doesn’t mean it will con-tinue. In fact, once you’ve had a good run you’re at your most dangerous.Overconﬁdence is an absolute killer. . . . It doesn’t matter how well thingsare going, you should always kind of pinch yourself, take a step back, andask, ‘what can go wrong?’ In fact, the better things are going, the more youshould look at where your risks are and what the downside is.”29
CONFIDENCE—THE “GOOD” KIND
“I always knew I was going to be rich. I don’t thinkI ever doubted it for a minute.”
—Warren Buffett
“One of the most strikingly evident traits of allthe market wizards is their high level of conﬁ-dence. . . . But the more interviews I do with mar-ket wizard types, the more convinced I becomethat conﬁdence is an inherent trait shared by these
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traders, as much as a contributing factor to theirsuccess as a consequence of it. . . . An honest self-appraisal in respect to conﬁdence may be one of thebest predictors of a trader’s prospects for success inthe markets.”
—Jack Schwager30
Jack Schwager, author of the Market Wizards series, explains that anytrader who does not have “absolute conﬁdence in their ultimate successshould be cautious about entering the business.” Yet that conﬁdence mustbe grounded in reality. Great traders are conﬁdent they can manage volatil-ity and unexpected events because they are ﬂexible. Information that con-tradicts their positions is eagerly investigated. Great traders are realistic,adaptable, and prudent—they use good money management techniquesand recognize that they can lose.
Conﬁdence is largely learned through experience, as one becomescomfortable with one’s ability to cope with, and even take advantage of,market volatility. In great investors, conﬁdence underlies resilience follow-ing losses, and it allows one to change strategy on a whim. Conﬁdence liesatop an intrinsic sense of certainty and self-esteem, usually learned by suc-cessfully overcoming challenges, and conﬁdence itself perpetuates successin many businesses.
Conﬁdence is imperiled in traders who invest without a plan. Marketvolatility and unpredictability will quickly erode their self-esteem and un-nerve them. Self-discipline and preparedness are necessary to maintaininghealthy conﬁdence.
Dr. Van K. Tharp, a psychologist who works with traders and investors,suggests that one of the most basic traits of winning traders is that they be-lieve “they’ve won the game before the start.” A European researcher whomailed a survey to hundreds of currency traders discovered that a “tacklingattitude” is deemed necessary by traders for success in their line of work.31Other investigators report that decisiveness is essential for traders, regard-less of the stressors they are facing on or off the trading ﬂoors.32
All of these traits—supreme self-assuredness, a tackling attitude, anddecisiveness—are developed through competence and experience. Feelinghumility in the face of the markets and yet “comfortable in my own skin”are important for traders. Given that healthy conﬁdence can easily growinto unhealthy overconﬁdence, how can one maintain perspective?
The appropriately self-conﬁdent are humble and realistic, but alsoprepared and assured. The overconﬁdent are self-centered and narcissis-tic. They blame external circumstances for their mistakes and take creditfor chance successes. The best word to describe the difference between
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overconﬁdence and self-conﬁdence is ego. Overconﬁdent people put theirego in the game. It’s all about them.
SOLUTIONS
Overall, overconﬁdence leads to a number of mistakes in decision making.The overconﬁdent attribute bad outcomes to uncontrollable circumstancesand good outcomes to their own excellence. Furthermore, they have trou-ble learning from feedback that is not immediate because they have a hind-sight bias—they are less likely to try to learn from their mistakes becausethey think “I knew it all along . . . I’ll prepare better next time.” They thendistort feedback so it feels better and makes them appear in a favorablelight.
In one study, educational seminars reduce the effects of one behavioraleffect of overconﬁdence (not saving enough). Education may attenuateoverconﬁdence in other arenas as well. A technique for minimizing over-conﬁdence among individual investors involves alerting people to the na-ture and negative consequences of overconﬁdence.33 Among venture cap-italists, studies have shown that improved knowledge may improve theirdecision quality and minimize the effects of overconﬁdence.34,35
Besides education, journaling can be an effective (if time-consuming)way of self-correction. Journaling involves keeping written records of one’sthought process (logic), subsequent decisions (actions), and outcomes (re-sults). If one reviews his journal entries periodically, he may see patternsof thinking that underlie bad decision making. The journaling process isdescribed in detail in Chapter 21.
Siva-Jothy reports, “I impose discipline on myself by keeping a tradingdiary. Every morning I go through the same process: If I have my positionson, I ask why do I have the positions? What has changed?”
Siva-Jothy describes the primary qualities he looks for when hiringtraders as “passion and humility.” Passion is a product of a strong rewardsystem (particularly the NAcc), and humility is an antidote to overconﬁ-dence. Furthermore, conscientiousness is crucial if one is to learn frommistakes and keep one’s passion well directed: “Integrity is the single mostimportant thing to me in hiring.” Regarding his own trading success, Siva-Jothy comments, “A lot of this is luck, but humility is probably the mostimportant thing. . . . You also have to enjoy it. Too many people come intothis business for the money, and that’s not going to work out over time.”36
The next chapter will report on the emotional ﬂip side of overconﬁ-dence—fear.
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C H A P T E R 9
Anxiety, Fear,and NervousnessHow Not to Panic
“If you spend more than 14 minutes a year worry-ing about the market, you’ve wasted 12 minutes.”
—Peter Lynch
Fear is uncomfortable, and it can drive investors to make rash, often
poor, ﬁnancial decisions. Fear can be so overwhelming that it over-rides reason, patience, and good judgment. When less intense, fear isexperienced as a gnawing sense of worry. In either form, fear has distinc-tive effects on ﬁnancial decision making.
Among investors, intense fear often leads to panicked selling. Manynovice investors ﬁrst experience panic when the price of a stock theyhave overweighted in their portfolio begins a rapid and unexpected plunge.Watching one’s wealth evaporate like this is a terrifying experience. Sur-prisingly, it’s not only inexperienced investors who experience intense fearduring the trading day.
Jim Cramer, former hedge fund manager, founder of TheStreet.com,and currently star of CNBC’s television show Mad Money, is intimatelyfamiliar with investing emotions. In one of the columns he wrote for ﬁ-nancial web site TheStreet.com, he described the feeling of being caughtin a rapidly losing position. In the following excerpt from that column,he is dramatizing the experience of being caught on the wrong sideof a short squeeze in the ﬁctional stock “National Gift.” Traders whoare short shares of a rapidly climbing stock experience a pressured“squeezing” feeling as they quickly lose money, hence the phrase “shortsqueeze”:
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Now the world is collapsing around you. Your breath, it isn’t happen-ing, it is forced. Your forehead is ﬂushed. You are sweating profuselyand you are scared. You can’t even panic. You can’t even react. Youcan’t do a thing.
“Buy 200,000 National Gift at the market!” you shout out as thehammer that’s been slamming your head instantly goes away. “Just&*$&ˆ#ˆ#ˆ@ buy the &*(%$&ˆ$ thing.”. . .
It has to do with fear. Fear is the real driver of stocks.. . . Headtraders like Todd Harrison can smell fear from symbols and prices.And you can never hide the smell of your own fear.1
Jim Cramer’s lucid account of panicked selling highlights two of thechief emotional obstacles for investors—fear and panic. Yet fear doesn’talways sabotage investors; by summoning courage, it can be used to one’sadvantage. Panic, however, is always a bad thing. While fear can crescendointo panic, they are quite disparate experiences. In this chapter I will pri-marily describe fear and its ﬁnancial effects.
There are ﬁve principles essential to understanding fear and panic:
1. Fear leads to physiological changes in the body (forced breathing,
sweating, head pressure). Thus