How to fool yourself into thinking you’re a top investor

“I just love to take profits. I hear music when the cash register rings,” the trader Marty Zweig told Jack Schwager in Market Wizards. Who doesn’t?

Investors are often advised to let their profits run, but banking gains feels good. It may also make us feel clever – even if we’re anything but.

A forthcoming Journal of Finance paper, Disposed to Be Overconfident, suggests profit-taking can distort our memories and judgment.

When judging their stock-picking abilities, ordinary investors rarely bother with overall portfolio returns or comparisons with the market. Instead, the study says, they use a simpler scorecard: how many stocks they sold at a profit versus how many sold at a loss.

By selling winners quickly, holding on to losers, and remembering the former more fondly, investors convince themselves they are better stock-pickers than their overall returns suggest.

The researchers found evidence of how skewed this scorecard can be. Ordinary Dutch investors recalled selling an average of 4.22 stocks at a profit over a year, almost twice the 2.17 recorded in their trading histories.

In a subsequent experiment, traders who were forced to sell winning stocks became more confident of their abilities than those forced to sell losers. And yet, the two groups picked virtually the same number of winning stocks and made almost identical overall profits. Simply realising a profit made people feel more skilful than they really were.

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The researchers link this to the disposition effect, the tendency to sell winners too early while hanging on to losers. The resulting scorecard is flattering, with profits banked and remembered, while losses remain unrealised and out of sight.

However, it can drive a vicious cycle: profit-taking builds overconfidence, which encourages over-trading, which degrades wealth through bad timing and transaction fees.

Our pleasure in hearing the cash register ring is natural. However, the sound of money being banked doesn’t mean we know what we’re doing.