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Apprenticed Investor: Curb Your Enthusiasm

The ego issue may be subtler than you would expect; certainly, a prideful trader who is unable to admit he or she is wrong ends up holding losing positions longer than he or she should. That's an expensive flaw, and it's why investors who anticipate being wrong can more quickly -- and therefore less expensively -- cut losses.

But ego has an insidious impact on our analytical abilities as well. It is a subtle form of bias inherent in our thinking process. Ego is why we selectively perceive data, why we emphasize that which confirms our prior views. It helps us ignore new data that may contradict our preconceived notions. It even facilitates our forgetting information that is inapposite to our viewpoint.

That's a pretty powerful analytical flaw hardwired into our brains, damaged or not.

We have other analytical flaws that are emotionally related. Why do we over-emphasize the most recent data point in a series? Each new economic report generates a giddy excitement, almost as breathless as a child the night before Christmas. When we consider the volatility of these data series, and the hedonic adjustments each one must suffer through, it's apparent that they are of more limited individual value. Smart traders focus on the trend of these releases, and not any one data point.

And yet...

We might have enjoyed 10 good GDP reports in a row, but let one bad one slide out and we become fearful and nervous. Or consider the opposite: we've just had over two years of data suggesting that inflation is resurgent, yet the first monthly report (June 2005) showing CPI and PPI as flat caused the Greek chorus to sing that inflation has been defeated in our lifetime. That's hardly the case.

Then, there are fear and greed. These are the best-known market emotions, and they cause all sorts of problems for investors. Our passions have an unfortunate tendency of getting the better of us -- and at exactly the worst possible moment, too. It's not merely chasing hot stocks at the top or getting panicked out at the bottom that's so problematic: It's the impulsive destruction of our investment strategy and long-term plan.
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