Introduction
Although we wrote this article for individual investors who manage their own money, the lessons apply to us all and reflect our approach to keeping our emotions in check when making investment decisions on your behalf.
When Confidence Meets Reality
After weeks of research, we’ve identified three companies that look perfect – strong fundamentals, growing market share, reasonable valuations. We pull the trigger and buy all three:
- Day one: The stocks are up 2%. We’re geniuses.
- Week one: Down 5%. Must be temporary market noise.
- Month one: Down 12%. Maybe we missed something in our analysis?
- Month three: Up 18%. We knew we were right all along!
Welcome to the emotional rollercoaster that every investor rides. The question isn’t whether we’ll experience these feelings – we will.
The real challenge is learning to navigate them without destroying our returns.
The Confidence Requirement
Investing requires confidence. Not the chest-thumping, “I’m always right” kind, but the quiet confidence that comes from doing our homework before putting real money at risk without the guarantee of success.
Without enough confidence, we’ll never pull the trigger. Many of us have over-analyzed risks instead of taking action – a phenomenon known as analysis paralysis. Unfortunately, money sitting on the sidelines misses out on positive returns that tend to appear roughly two out of every three years.
On the other hand, too much confidence can be even more damaging. Overconfidence blinds us to clear warning signs. I’ve seen investors ride stocks all the way to bankruptcy, and I’ve personally held positions down 70% before finally admitting defeat.
We are all imperfect and overconfidence is the issue we see most often in markets.
Overconfidence’s Three Warning Signs
- We Stop Questioning Investment Logic
Confident investors constantly test their assumptions. Arrogant ones dismiss contradictory evidence as irrelevant. - Position Sizing Goes Extreme
Confidence might lead us to invest 10% in our best idea. Arrogance has us betting the farm. As Warren Buffett said, “It is better to be approximately right than precisely wrong.” [1] - We Personalize Market Moves
The market isn’t ‘out to get us’ when stocks fall, and it isn’t ‘proving us right’ when they rise. When we interpret market moves as validation or persecution, emotions are driving the bus.
How Shifting Confidence Undermines Our Investments
Let’s walk through what happens when we buy a different stock we felt certain about:
- Purchase at $50: Excited but nervous – normal.
- Week 1 drops to $47: Our stomach tightens. This is our amygdala, the brain’s fight-or-flight center, triggering fear. [2]
- Month 1 drop to $44: Doubt creeps in. This is when most investors sell.
Checklist: review our reasons for buying the stock, check for new information, assess sector performance, and reconsider risk tolerance. - Month 3 rise to $59: Dopamine floods our brain, making us feel invincible. [3]
Ironically, the riskiest time is often after success. Overconfidence tempts us into reckless bets when the best move is patience.
Practical Solutions
Matching Investments to Risk Appetite
One approach: let position size reflect confidence. Supremely confident? 5–7% position. Moderately confident? 2–3%. Just confident enough? 1%.
At LUL Wealth Management, we use a slightly different approach that reaches the same goal. Every three months, we rebalance portfolios by equally weighting individual stocks but concentrating more heavily in favored sectors. This quarterly reset keeps both confidence and humility in check.
The smaller the risk we take, the lower our emotional intensity. It’s easier to think clearly about a 2% position than one at 20%. Several 2% losses keep us in the game. Two 20% losses? That’s devastating.
The Check-In Ritual
Every quarter, we ask:
- Are we still learning? If we think we know everything, arrogance has set in.
- Have we admitted mistakes? Owning errors opens the door to learning and discipline.
- Do we have varied conviction levels? If everything is a ‘high conviction’ bet, we’re likely overconfident.
- Are we sleeping well? Too much anxiety = oversized positions. Too much comfort = not enough risk-taking.
Our Goal
The perfect investor would be: (1) confident enough to act, (2) humble enough to admit mistakes, (3) convicted enough to hold through volatility, and (4) flexible enough to adapt when facts change. None of us are perfect, but we can recognize when confidence drifts toward arrogance or anxiety.
The sweet spot isn’t eliminating emotions – it’s recognizing them, understanding their source, and making decisions after calming their influence. The market doesn’t care about our feelings, but our feelings can hurt our returns. The more we act like the market – steady, unemotional, fact-driven – the more our investments will thrive.
References
- Buffett, W. (2006). Berkshire Hathaway Annual Meeting. Quote: ‘It is better to be approximately right than precisely wrong.’
- LeDoux, J. (2000). ‘Emotion Circuits in the Brain.’ Annual Review of Neuroscience, 23(1), 155-184. (on amygdala and fear response).
- Schultz, W. (2015). ‘Neuronal Reward and Decision Signals: From Theories to Data.’ Physiological Reviews, 95(3), 853–951. (on dopamine and reward).
Important Disclosures
This article is for educational purposes only and does not constitute personalized investment advice. All investing involves risk, including potential loss of principal. The strategies discussed may not be suitable for all investors. Consult with a qualified financial advisor to determine appropriate strategies for your specific situation.
Past performance does not guarantee future results. Asset allocation and diversification do not ensure profit or protect against loss. Examples provided are for illustrative purposes only.
LUL Wealth Management is a registered investment advisor. Registration does not imply a certain level of skill or training. More information about our firm’s investment advisory services can be found in our Form ADV Part 2, available upon request.