This Weakness Could Ruin Your Portfolio

Confidence is a great gift. It can lead people to do amazing things, like invest in obscure companies poised for amazing gains or start new businesses altogether. However, overconfidence can ruin everything in investing decisions, and business decisions, too.

When confidence becomes nonsense
For investors, the psychological "overconfidence" hurdle is no joke, and data back up its dangers. A study conducted by Terrance Odean at the University of California at Berkeley pointed out that overconfidence in one's own investing acumen leads people to trade too frequently, stunting returns. In addition, Washington State University professor of finance John Nofsinger covered similar topics in The Psychology of Investing, pointing out many investors' tendencies to overestimate the accuracy of the data they have on hand and their own ability to use it properly.

I've seen one variety of overconfidence firsthand when I've talked about real risks for stocks with cult followings. In rationally bringing up concerns about Sirius XM (Nasdaq: SIRI  ) , DryShips (Nasdaq: DRYS  ) , and Crocs (Nasdaq: CROX  ) , I've faced enraged readers and even personal insults. To decide to buy and hold such stocks while being aware of the risks is one thing, but refusing to acknowledge potential problems is foolhardy and dangerous.

Fundamentals like high debt levels, dwindling sales and profitability, competitive challenges, burgeoning inventory, and other completely factual data seem to matter not a whit to some types of investors, who may be way too confident about their investment theses. Soberly addressing very real risk helps avoid some terrible portfolio pitfalls.

Drinking the Kool-Aid, corporate-style
Overconfidence can indirectly hurt investors even when they're not the ones making the "overconfident" decisions. The time before the financial crisis showed what happens when business managers all "drink the Kool-Aid." Major problems ensued when too many folks at Citigroup (NYSE: C  ) , Bank of America (NYSE: BAC  ) , Goldman Sachs (NYSE: GS  ) , and now-defunct Lehman Brothers truly seemed to believe the stratospheric rise in housing prices and the subprime lending that supported it were sustainable. Many of those companies' shareholders suffered greatly when the shoddy premises finally fell apart.

Back then, just about everybody was a little too overconfident that housing prices "could never go down," making everyone from corporate brass to individual real estate speculators feel like geniuses ... until they realized they weren't.

On the corporate governance front, corporate managers might be too overconfident, and so might boards of directors. Runaway executive compensation might include overconfidence about certain individuals' abilities; too many CEO contracts and pay policies always assume performance is or will be great, instead of safeguarding against any possible negative outcome. Golden parachutes should be the exception, not the rule, and too many CEOs get paid handsomely for poor performance for years on end.

Bizarre business decisions like the one to pay Abercrombie & Fitch (NYSE: ANF  ) Chairman and CEO Mike Jeffries millions not to fly the corporate jet sound like overconfidence or overwhelming ego. Nobody thought shareholders might have a problem with that?

Psyched up or psyched out?
The marketplace has a very psychological component, and paying attention to the tendency to exhibit overconfidence might help us all make better investing, business, and life decisions. Being endowed with a reasonable level of confidence is one thing. Being certain nothing can ever go wrong, and allowing ourselves to be myopic to very real risks, is a recipe for disaster.

Check back at Fool.com every Wednesday and Friday for Alyce Lomax's columns on corporate governance.

True to its name, The Motley Fool is made up of a motley assortment of writers and analysts, each with a unique perspective; sometimes we agree, sometimes we disagree, but we all believe in the power of learning from each other through our Foolish community.

Alyce Lomax does not own shares of any of the companies mentioned. Try any of our Foolish newsletter services free for 30 days. The Fool has a disclosure policy.


Read/Post Comments (15) | Recommend This Article (27)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On September 24, 2010, at 3:20 PM, m55555 wrote:

    cry baby............

  • Report this Comment On September 24, 2010, at 3:32 PM, mpg242 wrote:

    Hmmm guess all my profits from investing in Sirius will have to be console's me at night.

    Thanks.

  • Report this Comment On September 24, 2010, at 3:34 PM, mpg242 wrote:

    Hmmm guess all my profits from investing in Sirius will have to console me at night.

    Thanks.

  • Report this Comment On September 24, 2010, at 4:46 PM, Fredlee009 wrote:

    no, actually you were attacked for writing false statements, incorrect facts, and generally misleading your readers. Nice try. Stop doing that, and well stop "attacking" you. Its called correctly you, not attacking. Tomato, tomaoe...

    Im sure u get it.

  • Report this Comment On September 24, 2010, at 4:53 PM, Fredlee009 wrote:

    Your the famous author of the classic worst article ever written, titled "Beware of Penny Stock Profits"... LOL

    Whos afraid of profits silly....

    AAHAHAHAHAHHAHAHAHAH

  • Report this Comment On September 24, 2010, at 4:53 PM, Fredlee009 wrote:

    1.18, score board!!!

    AHAHAHAHAHAHAHHAHA

  • Report this Comment On September 24, 2010, at 5:00 PM, lemoneater wrote:

    Have a pleasant weekend, Alyce. When investing I prefer not having my head in the sand and would rather know potential risks with a pick.

    I'm very enthusiastic about certain companies like ISRG, TTM, MMM, or TSCDY.PK, but no single position is over 8% of my portifolio. Diversification is a strategy I follow because I'm confidently cautious.

  • Report this Comment On September 24, 2010, at 6:38 PM, ItAintCool wrote:

    We don't attack you, we question your ability to actually know what you are talking about?

    I own Siri, got in with 50,000 shares @ .10. Sold it and bought it back during it's run of highs and lows in the past year. But to explain it to you In MF terms, I've got at 12-bagger. I still own my 50,000 shares, but now I just play with the house's money and pocket my profits at the right time and continue on playing.

    Why do we question your ability to know what you're talking about? Because you chose to ignore the facts behind your details and write less based on insight and more based on hyperbole. Remember your article "A Pandora's Box for Sirius XM" last month, that was trying to lead people to believe Pandora was the Satellite Radio killer with almost 60 million subscribers compared to Sirius' almost 20 million. Sure those numbers are impressive. On the surface Pandora is beating Sirius 3 to 1 in subscribers. Yet somehow you neglect to mention in that article that less than 1% of those Pandora listeners are actual "paid subscribers", meaning that Pandora is making at most about $600,000 in subscriber fees per month (perhaps a lot less). Yet Siri somehow has an estimated 15-16 million "paid subscribers" (I'm cutting out the estimated 3-4 million free trial subscribers currently using SIRI, which Mel K. says about 50% turn into paid subscribers) who are paying $10-$15 per month. (So let's say an average of 15 million subscribers @ $12 a month = $180,000,000 in subscriber fees per month - and that's a lowball estimate). Siri makes more in ad revenue than Pandora as well because it offers more diverse content than simply commercial-free music channels. Oh yeah, "content", another factor you seem to ignore in your praise of Pandora the SiriXM killer. I'm sorry, perhaps you were going to tell us about Pandora's news, talk-radio, comedy & exclusive content to compete with what Siri has to offer but didn't have room in the article *sarcasm*. People who subscribe to SIRI do it because there is a diversity of channels beyond music which makes it worth the money paid for it. They already take into account their discretionary income when they bought a subscription to Satellite Radio, and like cable-sat TV or internet connections, most can't do without it.

    Lest we not forget that Pandora also requires a constant streaming connection to the internet, which I believe for most smart phone users is another $60 a month (unless they're poor saps who don't have an unlimited download connection who pay a lower fee for limited download content- then they get really hosed with a streaming music radio service). That is assuming your phone service is actually capable of giving you a constant internet signal no matter where you drive. Of course, if you don't have the smart phone to listen to Pandora in your car. You can pay $1,200 for a car radio that hooks up to your cell phone carriers' internet service. Or, you could use the same $1,200 to buy 3 separate lifetime subscriptions to Sirius and never have to pay anything again.

    People love Pandora, why? Because it's free. But does that make it financially viable? As soon as Pandora asks for money to keep it afloat, watch it's subscribers dwindle into non-existence.

    And Alyce, when your Pandora is a "threat" to SiriXM article came out, August 30th, Sirius was @ .96, today it's at $1.18. My math skills are a little weak, but isn't that a 21% gain in 4 weeks. And with Barrington upping the target price to $1.50, it seems that many people think this stock has a lot more room to grow in the near-future and in the long term.

    Before I finish, I highly recommend a post by "waterinfo" in today's article by fellow MF Rick Munarriz (look in the comment section below the article). Waterinfo who gives an excellent perspective about the history of in-car entertainment and why Satellite radio will become the consumer standard in automobiles, now and in the years to come. http://www.fool.com/investing/general/2010/09/24/is-sirius-x...

    Long on Siri, short on Alyce Lomax.

  • Report this Comment On September 24, 2010, at 7:23 PM, southernbeachguy wrote:

    Hey Alyce, Sirus has had 4 straight Positive Quarters of Financials, who elso has had that in this terrible Democratic Economy?

  • Report this Comment On September 24, 2010, at 10:34 PM, doubting wrote:

    The problem is that your ignorant writings insulted sirius community that follows the stock very closely and puts any siri news or opinions under serious scrutiny. You can only earn respect from people by displaying knowledge of the subject. You need to do your homework!!! Sirius XM will be a very profitable company not only in radio and television but also in general. We are already observing this momentum that will be getting much more powerful in the near future.

  • Report this Comment On September 25, 2010, at 8:32 PM, longtermgrowth09 wrote:

    Any with some experience will know that stocks selling for $1 are crap all the time. no exception on that matter. and by the way time will tell if alyce was right wich i think she is . good article alyce. the 3 companies you mention they dont have any real moat, no dividends and bad CEOS. The price of the stocks said it all.

  • Report this Comment On September 26, 2010, at 4:16 PM, bkichuck wrote:

    Hey southernbeachguy, Democratic economy, REALLY? It must be really nice in your imaginary world.

    Go Sirius!

  • Report this Comment On September 27, 2010, at 1:44 PM, mbl1234 wrote:

    Your premise is perfectly illustrated by the usual looney Sirius mouth-foamers above, Alyce. LOL.

  • Report this Comment On September 27, 2010, at 7:04 PM, ViolaLeeBlues wrote:

    I think most of the comments failed to even address what the article was about. If you're happy owning Sirius more power to you. The one sentence mention of concern over the stock doesn't seem to justify the tirade of comments. Following is what the article made me think about.

    The dot com bubble of the late 90's. I was going to school for computer science and was very entusiastic about open source software projects. I used a combination of Linux & FreeBSD at my work to run email and domain servers. I was learning Perl which i really liked. There was MySQL which i thought was great Data Base option. I wasn't buying technology stocks but I was acutely aware of the buzz around them. This was probably even more amplified because I grew up in northern California. I remember being at the barber in the summer of 1999 and listening to a conversation in which several of the customers were saying that you "COULD NOT LOOSE MONEY" in technology stocks. Going on & on about the new economy and how Nasdaq would go up forever and all sorts of frenzied unrealistic over confident talk. If I was ready to buy stocks at the time (I was only 23) I probably would of been sucked into this frenzy. I was excited about the VA Linux IPO because an open source consulting firm seemed like a good idea. I was supprised by it's astronmical first day opening.

    I didn't get sucked into the real estate frenzy and I do remember thinking how similar it seemed to the "irrational exuberance" of the dot com bubble. They say you shouldn't buy stocks that you're in love with. I kind of disagree. I am smitten with google. Back in 1999 a friend had me open it up in my browser and search "more evil than satan himself" which opened up a Bill Gates bio page. I disagreed then and even more so now but I did find it somewhat amusing. What I really liked about Google is that it almost always found what I was looking for and I haven't used any other search engine since 1999 because it works so well. I never bought the stock because it has always seemed overpriced based on current or even possible future profits but I think it is a great company none the less. Netflix is another company I'm in love with. I have been a loyal subscriber since 2001. I could go on & on about why it's so great but I won't. I did buy stock in this company for about a year as the price fluctuated between 15 to 30 dollars. At the rate of about 1 to 2 shares per week. I wish i could of bought more. I was confident that the company was well run and impressed with their subscriber growth goals. I then held onto it for several years during which the price didn't move much. It was my confidence that the company was a great well run company along with my feeling of affection for what I thought was the terrific quality and value of their product which made me hold onto it. It is the best investment I have made to date.

    Anyways I for some reason I am very chatty today. I enjoy reading your articles Alyce. I like that the Motley Fool offers multiple opinions and ideas on the same subjects which are often at odds with each other. Keep up the good work.

  • Report this Comment On September 29, 2010, at 2:42 PM, TMFLomax wrote:

    Thanks for the feedback and thoughts, folks! I enjoyed reading what everybody had to say on this topic.

    Best, Alyce

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