A psychological or behavioral trap that leads people to believe that they have superior skill in some areas. The superiority trap can be a dangerous delusion in the stock market, since investors who believe their investment prowess is superior to that of others may end up losing a lot of money. One way of avoiding this trap is through retaining a sense of humility, rather than hubris. An oft-cited example of the superiority trap is the fact that the overwhelming majority of people think they are above-average drivers, which is a contradiction in itself.
Investors trapped in the superior state of mind have inflated views of themselves. They are overly confident in their capabilities and investments, and they may reject good independent advice, which could lead to errors in their own judgment. The superiority trap may have been the root cause of some of the biggest financial blow-ups in history. A prime example is the collapse of Long-Term Capital Management in the late 1990s. While LTCM’s distinguished Board of Directors included Nobel Prize winners in economics, this brainpower was not enough to avoid a loss of $4.6 billion in less than four months after the Russian financial crisis of 1998.
Another illustration of the superiority trap is that of an investor adding recklessly to a losing position, backed by the assumption that he or she knows better than the market. The investor is optimistic that the market will eventually see the stock’s value proposition and push it higher. But if the stock continues to decline, the investor will eventually have to cut losses and close the position.