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terça-feira, janeiro 31, 2006

Don't Let Overconfidence Undo Your Winning Streak


Skip has been successful in everything he has tried: sports, academics, and business. He recently started trading to prepare for his retirement. He's done well, and last week made huge profits after a long winning streak. He is psyched up and optimistic. At this point, there are two ways Skip can go. He can either stand aside, and let his optimism wane, or he can jump back in the markets, and potentially give back his profits. A study by behavioral economists Brad Barber and Terrance Odean showed that young traders like Skip tend to take unnecessary risks after a huge windfall. They overtrade and tend to end up with lower account balances than traders who did not have a windfall. Trading expert Martin Pring in "Investment Psychology Explained" notes, "after a long winning streak, almost every investor and trader falls into the trap of thinking that he is infallible." If you want to stay profitable, it is vital that you control your optimism.

Everyone wants to be good at trading. Not only will you have more money and status, but you can have pride in knowing that you've developed a skill that few possess. You are one of the elite who mastered the markets. Rewards usually go to the humble, though. The markets have a way of exposing the arrogant trader who feels omnipotent.

Martin Pring offers a few guidelines for how to control your optimism and stay profitable. The first step is recognizing that you may have a problem with pride and overconfidence. Admit that you are human, fallible, and can make mistakes. Once you admit that you are human, you will feel free and be willing to look at past trades more objectively. If you think, "I'm the greatest trader in a decade," you won't be willing to look for faults in your trading plans. But if you think, "I'm human; I'm fallible, and of course I make mistakes," you will look at your past trading plans with a critical eye and you'll surely find ways to improve.

Second, focus on potential risks before potential profits. Traders who are overly optimistic tend to focus on the positive aspects of a trade, specifically how much money they will make. It's more important to focus on how much money you may lose, however. If you focus on what you can lose, you'll avoid risky, low probability setups. You'll search for less risky trades that have a better chance of making a profit. Third, develop a clearly defined trading plan with a clear exit strategy. Determine either a point where you decide the market has moved against you or a profit objective where you take profits and close the position. Committing to a specific trading plan will help curb your over-enthusiasm.

Finally, it's useful to move profits out of your account occasionally. For example, once you reach a 20% profit objective, take the money out so you will have a feeling that you have to start over again. You may also want to take a break from trading to feel that you have to "start over," sort of like summer vacation at the end of the school year. When you come back, it will feel like starting a new school year with new challenges. This strategy will help you control feelings of overconfidence after a big win. Many traders allow overconfidence to wipe out the profits they have just made. Don't give profits back. If you stay humble, you'll increase your chances of staying profitable.

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