Education

Making sensible investment decisions is difficult. We are subject to a range of behavioural biases. We have to cope with incessant noise around financial markets. We behave in ways that are inconsistent with our long-term investment objectives. So what can we do about it?

Six Tips for Better Investment Decision Making

The first step is to understand that we cannot rid ourselves of bias. Nor can we hope to ignore all the noise. However, we can take six simple steps to achieve better outcomes; three dos and three don’ts.

  1. Do have a long-term investment plan.
  2. Do automate your saving.
  3. Do rebalance your portfolio.
  4. Don’t check your portfolio too frequently.
  5. Don’t make emotional decisions.
  6. Don’t trade! Make doing nothing the default.

1. Have a long-term investment plan 

Writing down the answers to a set of obvious questions about your investments can help you focus on long-term strategy. The answers can help you make considered, consistent decisions.  

Questions include:

  • why am I investing?
  • what is my time horizon?
  • why have I chosen this particular portfolio / investment / manager?
  • am I comfortable with the temporary losses that could result in difficult market conditions? and
  • what would I do in such a situation? 

This approach helps you ensure that your investment decisions are prudent and realistic. Revisiting your strategy can help during times of market stress. How you think you will act during a sustained stock market decline can be different from what you actually do. In a cool, rational state you may plan to add money at more attractive prices. Without a clear plan, amid the stress of losses and negative news stories, you might instead sell.  

There are no guarantees that referring back to a long-term plan will prevent you making poor decision. But rehearsing future scenarios can have a significant impact on future behaviour. 

2. Automate your saving

Learn the lessons of the “Save More Tomorrow” scheme and save according to predetermined rules. Committing to regular saving removes the emotional effect of market moves on your investment decisions. You will reduce your loss aversion. If the market falls sharply, you will be buying more at lower levels. If it rises, your existing holdings will have benefitted. 

By agreeing to increase your contribution every time your wages rise, you will never experience a loss in take-home pay through your pension saving.

3. Rebalance your portfolio

One simple and effective decision rule is portfolio rebalancing. A structured and consistent approach to rebalancing a portfolio back to target weights removes the need for human judgement. It cancels out market noise. (Indeed, rebalancing can become a source of return when noise temporarily takes prices further away from fair value.) It ensures that your portfolio does not stray too far from its desired allocation.

You will consistently sell assets that have outperformed and reinvest in those that have lagged. 

4. Don’t check your portfolio too frequently 

The more frequently we check our portfolios, the more short-term we become. This can make us too risk averse.

Today’s investors enjoy increased transparency and control over their portfolios. This brings many advantages. Unfortunately it can also bring with it a range of behavioural problems for the long-term investor. Viewing our portfolios on a daily basis creates the urge to trade, often at the worst possible times. 

Investors should focus on setting a sensible investment plan. Once this is in place, we should try to restrict our observations to an appropriate frequency. Once a month, once a quarter or even once a year is usually sufficient in the author’s view.  

There  are a number of gentle nudges that investors can use on themselves. For example, set a password for your investment account that is difficult to remember. Or store the password somewhere it takes a modicum of effort to retrieve. By making something more difficult to do, we can change our behaviour.

5. Don’t make emotional decisions

How we ‘feel’ at any given point in time can influence how we perceive risks and assess opportunities. Making an investment decision in an emotional state – excitement or fear – is fraught with problems. If emotion is overwhelming your thinking, postpone the decision. If the idea is a good one today, it is still likely to be tomorrow.

6. Don’t trade! Make doing nothing the default

The more we are bombarded with news, information and opinion the greater the temptation to react. This can lead to costly overtrading, and investments being whipsawed between the latest fad or fashion. For a variety of reasons, doing nothing is the hardest decision to make for an investor. But it is often the correct one.

To be clear,

‘doing nothing’ does NOT mean sitting in cash. ‘Doing nothing’ means doing nothing that takes you away from your long-term investment plan. 

Four thinkers on thinking 

Four books changed the way we think about thinking. Thinking, Fast and Slow by Nobel Prize winner Daniel Kahneman condenses a lifetime’s work into a highly readable book. He introduces us to our most important behavioural biases. Influence by Robert Cialdini sets out the six shortcuts that people use to get us to say “yes”. The Checklist Manifesto by surgeon Atul Gawande explains why checklists are a powerful tool to help us achieve consistency. Expert Political Judgement by Philip Tetlock identifies four obstacles to good judgements.

Thinking, Fast and Slow

If you are only going to read one book on behavioural economics, this is the one. Psychologist and Nobel Prize winner Daniel Kahneman condenses a lifetime’s work into a highly readable book. While there have been challenges to the replicability of some of the studies cited, the book remains the one ‘must-read’. Kahneman contends we think in two ways. System one is fast and intuitive. System two is slow and rational. Using system one is effort free, while system two requires work. Most of the decisions we make in life are made by system one. Our intuitions are right most of the time. But they are the source of our many thinking errors – or biases. Understanding our biases does not allow us to overcome them. Instead, better decision making happens when we design processes that cope with these biases. Khaneman helps us understand when we can rely on our instincts and how we can counteract our biases.

Influence: The Psychology of Persuasion

Psychology professor Robert Cialdini’s influential book sets out the six shortcuts that people use to get us to say “yes”.

  1. Reciprocity. “People are obliged to give back to others the form of a behaviour, gift or service that they have first received.”
  2. Scarcity. “People want more of the things they can have less of.”
  3. Authority. “People follow the lead of credible, knowledgeable experts.”
  4. Consistency. “People like to be consistent with the things they have previously said or done.”
  5. Liking. “People prefer to say yes to those that they like.”
  6. Consensus. “People will look to the actions and behaviours of others to determine their own.”

These six principles can help you influence others. Understanding them will help alert you to the tactics people use to influence you. 

The Checklist Manifesto: How to Get Things Right

Atul Gawande is a professor of surgery at the Harvard Medical School. He and his team have developed a simple to-do list that led to dramatic improvements in infection rates.

Gawande demonstrates that many errors come from ineptitude rather than ignorance. We know what we should do. But we do not apply this knowledge consistently and correctly. A checklist is a powerful tool to help us achieve consistency. It forces us to actively acknowledge that we have carried out every step of an agreed process.

A checklist is particularly powerful in situations where there is one right way of doing things. An airline pilot will follow the same procedure every flight. But they can still be useful in fields like fund management where decisions are less clear cut. They also force us to revisit previous errors.

Culture plays an important role in the effective use of checklists. The nurse must be empowered to point out the error of the surgeon, the co-pilot the error of the pilot.  We must be willing to learn from our mistakes.

Expert Political Judgement

Psychologist Philip Tetlock identifies four obstacles to making good judgements.

  1. We prefer simplicity. This means we make poor judgements in complex situations.
  2. We have an aversion to ambiguity. This leads us to poor decisions in inherently ambiguous situations.
  3. We have “a deep-rooted need to believe we live in an orderly world”. We see the shapes of animals in clouds. And find patterns in financial data that are equally short-lived.
  4. We are unable to accurately judge the role of chance. Many of our errors of judgement are due to our inability to intuitively calculate the true odds of potential outcomes. 

Conclusion

We cannot control markets, but we can learn to control our own behaviour. We can close the gap between what we plan to do and what we actually do. This ‘behaviour gap’ has a cost. When we fall victim to our own biases, we lower the expected return on our portfolio.

The first step to making better decisions is to better understand the biases that influence those decisions. We need to understand these biases in order to overcome them.

We have too many biases to capture them all in this paper – or in our decision-making process. We identify the seven major impediments to effective investment decision making and provide the ‘MIRRORS’ checklist to address them. 

We need to turn down the volume on noise. Resisting the urge to check our portfolio on a daily basis – or to trade on the latest news story – will make it easier to stick with our long-term investment strategy

We offer six simple steps to improve decision making; three dos and three don’ts.

  1. Do have a long-term investment plan.
  2. Do automate your saving.
  3. Do rebalance your portfolio.
  4. Don’t check your portfolio too frequently.
  5. Don’t make emotional decisions.
  6. Don’t trade! Make doing nothing the default.

These six steps seem simple but are not easy. We cannot remove our biases. Instead, we must build an investment process that helps us overcome them. This process will – and should - inevitably incorporate human judgment, but it must be included in a systematic way.

We hope this 3 part series helps you understand your own biases. And helps you achieve better long-term investment results. 

This is part three of a three-part series. Read parts one and two here.

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