Eye on Behavioral Finance: Confidence

“I always knew I was going to be rich. I don’t think I ever doubted it for a minute.” -Warren Buffet

Investors have a love / hate relationship with confidence. On one hand, being confident in your analysis, process, and team is critical to making sound and successful decisions. On the other hand, overconfidence, especially to the point of hubris will lead to risk taking, which can ultimately lead to losses that become insurmountable.

The word hubris finds its root in the Greek work hybris. In ancient Greece, hybris referred to actions of those who challenged the gods or their laws, which led to their eventual downfall. In fact, hybris was considered the greatest sin of the ancient Greek world. The story of Icarus is one of the most telling examples of hybris in ancient Greek mythology. Despite repeated warnings from his father Deadalus, Icarus was overcome with the giddiness of being able to fly and flew to close to the sun. He burnt his feathers, was no longer able to fly, and fell into the sea.

In investing it is critical to be aware of overconfidence and protect against the development of hubris, particularly after a recent period of success in the markets. This success can lead to, naturally, a feeling of overconfidence and more rampant risk taking. This psychology predicament is well known in many fields. In the military, this is referred to as “victory disease” as successful military commanders have a tendency to demonstrate poor judgment after a series of military victories. Napolean’s ill fated invasion of Russia is, perhaps, one of the more notable examples.

From an investment perspective, overconfidence creates at least three fatal flaws: miscalibration, better than average effect, and illusion of control.

- Miscalibration occurs when investors overestimate the precision of their knowledge and tend to use confidence intervals that are too narrow. In a paper by Graham and Harvey, CFOs were given a multi-year survey and asked to give their 80 percent confidence interval for stock market close over the next year. When over 4,300 forecasts were measured against the actually results, only 30.5 percent, or less than a third, were accurate within the 80 percent confidence interval.

- Better than average effect occurs when people grossly misjudge their abilities. This was highlighted in a recent Washington Post poll in which, “94 percent of Americans said they were above average in honesty, 89% in common sense, 86 percent in intelligence, and 79 percent in looks.”

- Illusion of control involves the belief that one may be able to influence random events. In a famous study by Langer and Roth, participants were asked to flip a coin ten times with rigged results. When asked how they would do in a game of 100 flips, those who started with a series of wins expected to do much better and, additionally, almost forty percent believed they would get better with practice.

Overconfidence is much more than just a behavioral economic trait that we need to be aware of it, it also has an actually physiological foundation in the way of dopamine, which is a chemical that the body generates to reward “success” and by creating a feeling of pleasure. Keith has previously posted on the impact of dopamine and Richard Peterson summarizes this effect well in his book “Inside the Investor’s Brain”:

“The dopamine-based reward learning process encodes a profitable pattern of behavior. Subsequently, however, highly profitable traders may have difficulty maintaining the same level of attention to risk management because of a chemical shift in their brains. They become slightly bored and push the limits of their abilities and risk exposures in order to continue to feel challenged. The combination of low relative dopamine levels during during trading (because they have already learned profitable techniques) and elevated norepinephrine levels provokes increased boredom, distractibility, and scanning for new opportunities.”

Too much success, in effect, can change an investor’s brain and lead to chemically based overconfidence that will lead to excessive risk taking.

To be clear, as we attempted to highlight in the quote from Buffet at the start of this note, confidence in your abilities is also critical in the achievement of investment success, and success in life broadly. If you do not believe in your process and your team, then your ability to make timely decisions will be limited, but this confidence must be framed in rationality. In effect, you can only achieve what you believe you can achieve. As Jack Schwager wrote in Market Wizards:

“One of the most strikingly evident traits of all the market wizards is their high level of confidence . . . But the more interviews I do with market wizard types, the more convinced I become that confidence is an inherent trait shared by these traders, as much as contributing factor to their success as a consequence of it . . . An honest self appraisal in respect to confidence may be one of the best predicators of trader’s prospects for success in the markets.”

A starting place of any success, whether in investing or otherwise, is in confidence, but at the same time we must be very wary of the pitfalls of overconfidence. A method we use at Research Edge is to keep investment journals. While this seems trivial, it is also a way to quickly and accurately verify when your success is based on skill versus luck. It also provides us the ability to look back and learn from our mistakes.

Daryl G. Jones
Managing Director

Quote Of The Week: John Mack, CEO, Morgan Stanley

"MUFG’s investment is a powerful endorsement of the tremendous value in the Morgan Stanley franchise, but the caliber and commitment of our people give me even greater confidence about the future of this Firm,”...
-John Mack, 2008

This, of course, is Morgan Stanley’s version of a white knight, MUFG (as in Mitsubishi Financial)... as in the Japanese firm that cut their outlook by another 50% versus expectations this week and announced that they need to find another 990B in Yen of liquidity...

The aforementioned quote by Mack, was not one he made this week. He said it earlier in the month, when guiding the Street to whatever light he saw in levering MS to another over-geared bank. There have been multiple points in this economic downturn's history that the said leaders of "Investment Banking Inc." and the US Treasury (are they one and the same?), have issued global investors short sighted perceptions versus reality. Our promise is to ‘You Tube’ them.

If the excuse is that “no one could have proactively seen this financial tsunami coming”, we’re short that. If there is no proactive risk management or research process, we’ll just call it out for what it is – being wrong.

We hear, quite often, that Mack is a good guy. This quote is unfortunate.

Chart Of The Week: A Great Week For Capitalists!

This was a great week for capitalists!

Our chart of the week is the +14.6% squeeze rally in the S&P500 (from the intraday Tuesday low of 845 to Friday’s closing high of 968). The “I am going to cash” crowd’s call to arms looks a little late now. The US market has closed UP, on a week over week basis, in 2 of the last 3 weeks.

This was a great week for America’s new capitalists –being liquid and long trumps being levered with debt.

Hedgeye Statistics

The total percentage of successful long and short trading signals since the inception of Real-Time Alerts in August of 2008.

  • LONG SIGNALS 80.52%
  • SHORT SIGNALS 78.67%

CHUX – Removing CHUX from the dreaded list

I’m officially removing CHUX from the Restaurants @ Research Edge bankruptcy list. The remaining players on the list include DIN, RUTH and RT.

On the 3Q98 conference call CHUX’s management said they would limit capital spending to only maintenance capital spending. The balance of the cash would be used to reduce debt by the end of fiscal 2009. Unfortunately, that alone would not eliminate the potential of being in default of their bank credit agreement if business trends remained on the current trajectory.

The only answer is a liquidity event for the company. Currently, the company owns the land and building on 100 stores, of which 15 are not pledged as collateral to the banks. I believe that company will do a sales leaseback on the 15 properties to generate cash and repay the bank debt. The transaction will be dilutive to EPS as the lease payment will be higher that the interest on the bank debt, but the risk of default is eliminated. The sale-leaseback will not happen all at once, but over the next 3-4 months.

A liquidity that eliminates the potential for default will be a significant catalyst for short covering.


Light sweet crude, the primary grade traded on the NYMEX, is on its way to the biggest single month decline since futures contracts for it started trading in 1983. The sellers are focused squarely on demand: concern over the cooling global economy is trumping OPEC’s saber rattling, at least for now.

We continue to think oil is something to trade here, not to own.

Our near term buy trade level is 59.62
Our near term sell trade level is 67.14

We would keep stop losses in place in either direction.

Keep a trade a trade to stay in the game.

Andrew Barber

RUTH – Desperate Times

I commented back in September when RUTH announced its sales-leaseback transaction that the banks appeared to be driving the process at the company. At the time, management stated that it had pursued the transaction to increase free cash flow and “ensure maximum operating flexibility.” I argued the transaction achieved the exact opposite and that owning real estate and not paying rent actually provides more flexibility. Instead, I think the company was motivated to do the sales-leaseback by Wells Fargo which wanted RUTH to use the cash proceeds to reduce its outstanding debt balance.

Yesterday, RUTH announced that it has completed additional cost reduction initiatives, including a cut in the number of corporate personnel. The company estimates that these cost reductions will generate annualized savings of approximately $2-$4 million on top of the previously announced annual expense efforts of about $8 million, resulting in about $3-$4 million of savings in 2008 and $10-$12 million in 2009.
Again, management stated in its press release that these cost reductions were completed in order “to maximize free cash flow and manage the business to preserve [its] flexibility.” The press release went on to say that “these changes are necessary in order for our organization to maintain stability in the current operating environment” and that “these actions were also taken in an effort to rationalize the company’s infrastructure from one intended to support material new unit growth, to one with a significantly reduced development outlook.”

I would agree that these recent moves to eliminate costs will provide the company with more flexibility, but again, like the sales-leaseback transaction, I think the need to implement these cost savings initiatives points to RUTH’s current desperation. The company is doing anything it can to survive in the current environment. Making matters worse for RUTH, although not surprising relative to recent comments from other casual dining operators, the company also stated that the challenging trends through 3Q08 deteriorated further in October. RUTH’s comment about its significantly reduced development outlook, however, highlights a definite step in the right direction…better late than never.

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