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Tame your brain

What can investors do to overcome common behavioural mistakes? Algy Hall identifies seven ways to beat the biases that can ruin our investment returns
Tame your brain

People who take an interest in behavioural finance often quickly run up against a depressing fact: there is next to no advantage in knowing about the mistakes caused by our propensity to shun considered and rational thought in favour of quick and effortless choices. These habits are so deeply ingrained that even when we know what we should not be doing, without safeguards we still do it anyway. 

However, there are a number of techniques that have been shown to help investors control common behaviours that damage investment performance. This seven-step guide provides practical advice on how to traverse the behavioural minefield and improve returns. But before getting on to how investors can build a behavioural edge, it is first important to understand the problem that everyone is up against.  

 

THE PROBLEM

Thinking is exhausting work. The brain devours between a fifth and a quarter of the energy used by the entire human body despite accounting for just 2 to 3 per cent of overall weight. The effort involved in rational thinking is particularly taxing and capacity is limited. The part of our brain that deals with slow, deliberate thinking – the prefrontal cortex – only accounts for about a tenth of the organ’s volume and spends most of its time pretty maxed out by the demands of modern life. 

Given the resources available, we are fortunate that the mind has a plethora of short-cuts that enable us to make fast-and-easy decisions that are often very effective. However, these short-cuts that are so important for actually getting anything done are also so seductively effortless that we often use them to make decisions that would be much better as a product of slow-and-effortful consideration. 

 

This very human paradox is captured in the title of the book that is a bible for many behavioural finance enthusiasts: Thinking, Fast and Slow by Daniel Karhneman.

Unchecked, the allure of lazy and emotional thinking can have disastrous consequences for investors. Listed here are five aspects of human psychology. While the list could be much longer (and definitions could be more granular), these five common behaviours are some of the most dangerous when it comes to investing. And bear in mind when reading the list that behavioural psychologists have been able to illustrate very convincingly that we’re all extremely prone to feel these traits apply more to other people than to ourselves. What’s more, the cleverer you are, the better you’re likely to be at fooling yourself.

 

FIVE BIG MISTAKES

Overconfidence

Overconfidence is the trait that Nobel-prize-winning behavioural psychologist Daniel Kahneman labelled “the most significant of the cognitive biases”. He has also said it is the bias he would most like to eliminate. The reason for Mr Kahneman’s choice is somewhat more laudable than boosting his bank balance. Still, overconfidence is one of the biggest issues investors face. 

Evidence of our overconfidence is everywhere – from frequent underestimates of the cost of high-profile infrastructure projects, to surveys that consistently show the vast majority of people consider themselves better than average at anything ranging from driving skill to moral character.

Author, finance professor and head of consilient research at Morgan Stanley Counterpoint Global Michael Mauboussin suggests it is useful to break overconfidence into three key areas: “overestimation” of one's own abilities; “overplacement” of how good oneself is compared with others; and “overprecision” based on belief in our own ability to answer difficult questions (and sometimes unanswerable ones!). He considers the third issue most problematic when it comes to investing.

Perhaps most dangerously, our biggest mistakes tend to occur when we are most confident – normally at times when we are buoyed by a recent run of success. This is a particular issue in our information-rich age as confidence tends to grow the more information we have at our disposal. However, there is often little connection between the accumulation of information and the actual quality of the decisions we make. 

One famous experiment into the phenomenon was undertaken by eminent psychologist Paul Slovic in 1973. He observed how the confidence of horse handicappers increased as he provided them with more information about horses taking part in races but also how there was absolutely no corresponding increase in their predictive power.

An important positive contribution made to our lives by overconfidence is in promoting our mental wellbeing, and memory seems particularly predisposed to providing us with comfort. For example, there is evidence to suggest we are better at remembering and learning from our successes than our failures. Meanwhile, a well-documented trait dubbed “hindsight bias” describes the struggle people have distinguishing what they knew at the time a decision was made from their after-the-fact justifications. Predictably, these justifications tend to be very sympathetic regarding one’s own decisions but much less so in regard to others. 

For all the comfort memory’s unreliable narrative brings, investors indulge this at their peril. Coupled with outcome bias (covered separately below) the rose-tinted perspective on the past represents a major obstacle to getting the reliable feedback needed to improve an investment process. 

Another dimension of overconfidence is that we tend to require very little evidence to accept new ideas when they are presented to us. This is useful to speed up learning, but can cause problems based on our willingness to accept low-quality, untested arguments and beliefs. In the words of psychologist and Stumbling on happiness author Daniel Gilbert, “believing is so easy, and perhaps so inevitable, that it may be more like involuntary comprehension than it is like rational assessment”. The problems associated with this particular trait are compounded by the difficulties we have in rejecting ideas once we do believe them, as we’ll find out next.

Take the rough with the smooth: Overconfidence encourages people to pursue ventures that can be hugely beneficial but where the odds are stacked against them (famously 9 out 10 start-ups fail, for example). This trait helps us bounce back from failure, too.

 

Confirmation bias

A key lesson from extensive research into forecasting undertaken by the academic and author of Superforecasting, Philip Tetlock, is that a significant amount of forecasting success can be attributed to the ability to constantly amend beliefs in response to events. This is one of the standout skills displayed by superforecasters – the top 2 per cent of those taking part in forecasting tournaments run by the CIA. Sadly, the ability to seek out and unbiasedly interpret information, especially when it goes against an existing belief, is a very rare skill indeed.

It is human nature to look for facts that support and confirm what we already believe while ignoring, or explaining away, anything contradictory. In 2009, the American Psychological Association released a “meta-analysis” titled 'Feeling Validated vs Being Correct', which assessed 91 studies covering 300 independent groups made up of a total of 8,000 participants. It found people were more than twice as likely to favour information that confirmed their view than went against it. 

Confirmation bias extends to the company we keep as well as the information we draw on. An innate desire to surround ourselves with people who think like us – and perhaps even more sinisterly, look like us – is a key contributor to the often disastrous phenomenon known as 'group think'. The social networking sites used by many investors and the algorithms such sites employ to create a cosseting, comfortable, confirmatory bubble for each user can be very dangerous in this regard. 

Confirmation bias is particularly insidious when cause and effect are very hard to understand, as is the case with investing. Under these circumstances facts are altogether more malleable and can easily be corralled to suit a preferred argument. 

To use a quote from Mr Tetlock’s book Superforecasting, “beliefs are hypotheses to be tested, not treasures to be guarded”. High-stakes poker champ and author of Thinking in Bets, Annie Duke, has similar advice for those trying to profit from their decision-making. She encourages us to “treat our beliefs as works in progress, as under construction”. 

Take the rough with the smooth: Confirmation bias helps us quickly assimilate new beliefs into our thinking, which makes us quicker to benefit from learned wisdom and new discoveries.

 

The endowment effect

It is often regarded as a virtue to want what you have. The good news is our brains seem to be hardwired for this type of thinking. The bad news is that this trait is rarely a virtue when it comes to investing. 

The endowment effect describes our tendency to put more value on things when we own them. A good example can be found in an experiment conducted by academic and author of Predictably Irrational Dan Ariely and his colleague Ziv Carmon. They studied Duke University students that had participated in a lottery for much-prized tickets to a basketball event. In a bizarre university ritual, students had to camp outside the stadium for a week just to be in the draw – they all really wanted those tickets. But a funny thing happened in the post-lottery market for tickets. The academics found students that had won tickets were only prepared to part with them at a price that was about 14 times higher than the students that hadn’t won tickets were prepared to pay ($2,400 vs $170). 

The extra value we put on things we own has major implications for investors making decisions to buy or sell. In particular, it suggests investors are prone to fall in love with certain investments and hang on to them for too long. 

The power of the endowment effect on decisions tallies with research that analysed more than 700 fund portfolios between 2000 and 2016 and found the average annual performance could have been improved by 0.7 per cent had sell decisions simply been made at random. 

Meanwhile, research consultancy Essentia Analytics has found that the performance of many investments by professionals resembles a “reverse horse-shoe”; big gains early on that are subsequently given back over the lifetime of an investment due to reticence to sell. This is something the firm’s founder and former hedge fund manager Clare Flynn Levy describes as “round tripping” and considers it one of the two biggest dangers faced by professional fund managers.

Take the rough with the smooth: This trait encourages us to protect and take care of the things we own and are responsible for.

 

Loss aversion

According to Ms Flynn Levy, the other biggest fund manager mistake identified by her firm’s research relates to loss aversion; what she calls “slow bleeders”. These are losing positions that fund managers do not cut quickly enough and often only sell at the bottom. Investors often use sayings such as “a loss isn’t a loss until you sell” as a veil to excuse this destructive emotional response to a poor investment. 

One of the many hugely influential findings by behavioural psychology pioneers Mr Kahneman and long-time collaborator Amos Tversky is that the pain people feel from a loss is around twice the pleasure experienced from an equivalent gain. This has many implications for investors as they try to balance risk and reward.

As well as the difficulties fund managers have with cutting losers, evidence of loss aversion can be seen in suboptimal conviction levels in portfolios. Research suggests the average fund manager’s best ideas (their biggest bets) tend to generate outperformance, but their portfolios tend to be padded out with many low-conviction positions that on average underperform (see our 'Follow the leader' feature from 30 April 2020). These smaller positions are often thought to only be there to reduce the chances of underperformance for a career-threatening length of time.

Some of the biggest investment dangers associated with fear of loss come at times of financial stress. Rather than selling high and buying low, our emotional response to loss means we’re pre-programmed to do the exact opposite.

GMO’s James Montier, the author of one of the best and most accessible books for investors on the subject of behavioural finance – The Little Book of Behavioural Investing – has a favourite experiment he cites to illustrate the point.  In 2005, a group of academics led by Baba Shiv set up a game where participants were offered the chance to bet $1 a time on a series of 20 coin flips with a $2.50 prize for each correct guess. Given the outcome of each flip is independent from the last and the odds are in the player’s favour, the rational thing to do is bet $1 every time. The researchers performed the experiment on distinct groups of participants: one group had a rare type of brain damage that stopped them feeling fear; another group didn’t have any brain damage. The fearless group bet 85 per cent of the time compared with 60 per cent for the others. But the really interesting thing was that while losses on previous rounds had no real effects on the behaviour of the brain-damaged group, the other group only bet 40 per cent of the time after having experienced a loss; action that was clearly illogical, sub-optimal and caused by loss aversion.

Take the rough with the smooth: This trait keeps us out of a lot of trouble.

 

Outcome bias

Having access to quick and reliable feedback is valuable. Indeed the research into forecasting by Mr Tetlock and his colleagues has found providing advice based on regular and reliable feedback is one of the best ways to train people to make better probability-based decisions.

http://journal.sjdm.org/16/16511/jdm16511.pdf

The trouble is, the stock market is particularly poor at providing good feedback due to the difficulty of disentangling the influence of luck and skill when assessing outcomes. In his book The Success Equation, Mr Mauboussin sets out “a quick and easy way to test whether an activity involves skill: ask whether you can lose on purpose. In games of skill, it’s clear that you can lose intentionally, but when playing roulette or the lottery you can’t lose on purpose.”

Even the most ardent admirer of their own investment skill would have to admit there is a roulette element to investing. This is a key reason why investors face such major issues with outcome bias; our propensity to judge the quality of a decision based on its results rather than the quality of thought at the time it was made. The problems of providing oneself with honest assessments on decision quality are compounded by the similar but distinct issue of hindsight bias (see Overconfidence).

Outcome bias, the role of luck, and the long time frames often involved in investing, all mean feedback on investment decisions tends to be very poor despite the financial results being tangible. Coupled with overconfidence, this means investors that keep getting lucky can misidentify skill in a flawed investment process right up until a calamitous day of reckoning. This is what risk and randomness author Nassim Taleb refers to as “picking up pennies in front of a steamroller”. A more colloquial way to put it being, “you only find out who's been swimming naked when the tide goes out”. 

Take the rough with the smooth: In a world full of uncertainties, it is useful to be able to draw a quick clear conclusion from an outcome rather than spend a lifetime pondering.

 

 

THE SOLUTION

Big data, machine learning, gobbledygook equations; a dizzying array of high-tech, hard-to-understand and high-cost approaches are employed by professional investors to improve investment decision-making and address behavioural issues. However, strip away the bells and whistles, and the most important steps to protect an investment portfolio from our human failings are actually reasonably straightforward. Being a good behavioural investor does take a bit of effort, and above all discipline and consistency. But the little bit of elbow grease that is required is likely to be hugely rewarded by the improved investment returns that should compound over time.

As well as drawing on the fascinating literature on decision-making and behavioural finance, our seven-step guide to building a behavioural edge is based on interviews with three pioneers in applying this knowledge to investment (see meet the experts box out). And if you’re only going to read a few of the steps, the first and the last are the ones recommended.

 

SEVEN STEPS TO BUILD A BEHAVIOURAL EDGE

STEP 1: Plan on paper

The first thing to do when investing is have a plan. This does not have to be complex. Greg Davies of Oxford Risk suggests that for many investors it would be enough to simply follow the three rules of: get your money invested; diversify; and leave it alone. The foundations of any plan should be based on an honest assessment of competencies, risk tolerance and the amount of time and effort available to devote to managing investments. 

Whatever the plan is, and whether the plan in question involves a single investment or rules of an investment process, the confines of one's head is a rubbish place to keep it. Write it down – or record it by some other similar means. 

Written plans can be especially valuable when markets are plummeting and cool-headed reasoning is replaced by blind panic. A separate plan should be put in place for what to do during a severe sell-off. Even if the rule is "do nothing", it should be put in writing. Both during a sell-off and more generally, ideas that do not get committed to paper (real or electronic) and made accessible for future reference can be treacherously malleable. Plans that aren’t written down are also far less likely to be acted on. 

“What you should ideally do is sit down with a piece of paper and actually start to write down rules for your investing that you can then follow and start to build into habits,” says Mr Davies. “Overwhelmingly, I think, making good decisions is not a matter of doing things in the moment. It's a matter of preparation and building up your knowledge and your capability to do so.”

A clear and succinct explanation of the act(s) needed to implement a plan and a similarly brief and clear account of reasoning is all that’s required. Focused bullet points are likely to be much more useful than a discursive essay in order to promote clarity of thought and provide a reference point for future review. What’s more, by keeping it brief, the discipline of writing is likely to be easier to stick with.

For documenting individual investment decisions – as opposed to rules governing the investment process – written plans can (and ideally should) be regularly revisited and revised in response to new information and events. Indeed, one danger with writing things down is that in clarifying our thoughts we can make our thinking rigid. Investors should regard everything that is written down as a work in progress rather than an end point.

In a nutshell:

  • Have a plan – for an overall investment process, for individual investments and for what to do in a sell-off
  • Write it down
  • Keep it brief

 

STEP 2: You talkin’ to me?!

We are far more willing and able to see fallibility in others than in ourselves. There’s little we can do about this and who would want to reverse such a psychologically advantageous arrangement. For investors that want a behavioural edge, it makes sense to try to take advantage of this trait by depersonalising judgements. 

When writing a new investment plan or updating an existing one, a trick is to frame thoughts as honest advice to someone whose interests you care about – a relative or friend perhaps. Objectivity can also be created by simply trying to answer the same question twice.

The timing of our investment decisions can also have a huge influence on how they are affected by our emotions. A decision made during trading hours in a savage market stands far less chance of being clear and focused. Readers of Michael Taylor's column will understand successful traders have to have an extremely disciplined approach. 

A rule to only make decisions after the market closes is likely to significantly improve clarity of thought. Waiting until the weekend, more so still. And a rule to leave all decisions to one weekend in the month or even once a year should provide even more space for rational reflection. This type of rule can be a real help in shoring up what Mr Davies describes as an investor’s “emotional reservoir”, especially at times of financial stress.

Another way to depersonalise thinking is to use numbers as a means of expression whenever possible. Numbers are less open to interpretation than words and therefore less susceptible to the vagaries of emotion. Numbers can also be used to express a wide range of things, such as allocation of money between different types of investments (such as the classic 60 per cent shares, 40 per cent bond portfolio) or as a way to express the probability an investment will come good. 

Expressing the expected likelihood of an investment working out in percentage-probability terms is a particularly powerful psychological tool. There are two key reasons for this. Firstly, using probabilities serves to reinforce the idea that even when outcomes are binary (win or lose), we make decisions based on a sliding scale of probabilities. For example, on a six-sided dice the number two will only be rolled around 17 per cent of the time. That means it would be right to bet against two coming up even though it will prove a losing bet sometimes – ie it is not that the decision was 'wrong' even though the bet was lost. 

Secondly, percentage probabilities can be changed regularly, and by a little or a lot depending on what new information is available. Mr Tetlock’s work shows frequent updating to be a key attribute of the best forecasters. Mr Maubuossin has a straightforward method to record investment decisions using probabilities, which is also particularly good at helping provide investors with feedback (see Step 6). 

Succinctly write down: 

(i) what you think you know that the market is not pricing in. 

(ii) when and by what objective indicator will you measure the success of your prediction (eg broker profit forecast upgrades of 10 per cent or more, a 100 basis point margin improvement etc.). 

(iii) the probability of success expressed as a number (eg 60 per cent). 

Revisions to probability assessments should be kept for review as the information about how confidence evolves can hold valuable clues about how timing (buying/selling) and position sizing could be improved.

In a nutshell:

  • Frame written plans as advice to others
  • Avoid making decisions in the heat of the moment
  • Express plans using numbers, especially probabilities

 

STEP 3Devil’s advocate worship

The more an investor allows their views to go unchallenged, the more disastrously wrong they risk being. What is cosseting and cosy for the short term (not being challenged) may end up being excruciatingly uncomfortable in the long term (a large financial loss). 

One of the most effective ways of improving decision-making that researchers have identified is to compare predictions to a 'base rate'. A base rate reflects what has happened in similar situations in the past. Harking back to the dice example, if we didn’t know how a dice worked but did know in the past it had rolled a two about 17 per cent of the time, this would be a valuable base rate. Such comparisons are also sometimes referred to as an 'outside view', which offer an objective counter-balance to the subjective 'inside view'. The important thing here is that investors should actively hunt for unbiased information that they can compare and test their beliefs against in order to keep expectations rooted in reality rather than fantasy.

Mr Mauboussin, who compiled the free-to-access base-rate goldmine Credit Suisse Base Rates Book, says: “I think where [base rates] work most effectively is when we have well-behaved distributions of outcomes. So things like revenue growth rates are not perfectly normally distributed – there's always going to be an extreme company because the distribution is going to shift over time – but for the most part there's going to be a lot of value in applying [base rates]... Where the distributions are heavily skewed or even the notion of a mean average is nonsensical, it's going to get much more difficult.”

Another way to test the 'inside view' is to actively seek arguments that run directly counter to your position. Simply asking “why am I wrong on this?” and writing the answer down can also be a powerful corrective.

Trying to become part of a group with diverse viewpoints that is prepared to enter into genuine honest exchanges is also invaluable for anyone lucky enough to find such a network. However, groups that do little to challenge existing views and much to confirm them can be very dangerous as they may well foster groupthink – extreme confirmation bias.

In a similar vein, investors should try to exploit the wisdom of crowds whenever possible by aggregating forecasts. For example, it is always worth paying more attention to consensus broker forecasts than any individual broker’s forecast unless there is very good reason to think the consensus is flawed.

It is also important to remember that in normal circumstances one’s mind is an unreliable narrator that is desperate to paint its owner as the hero of the piece. So when assessing how amazing our ideas are, we should always dial back the self-assessment – even if this feels like a ludicrous act of self-flagellation. Individual experience is likely to be the best guide to how far that dial needs moving (see Step 6).

“Anything outside of your circle of competence, you should not be making decisions about without a lot of stringent processes or bringing in an adviser,” says Mr Davies. “Never assume that something's inside your circle unless you've sat down and thought about it really carefully… if you start making lots of decisions about things you don't really know much about, you're kind of gambling against the universe with the wrong odds.”

In a nutshell:

  • Find a base rate
  • Search out views different to your own
  • Try to answer the question, “why am I wrong?”

 

STEP 4: Unpack your thoughts

Investors often have to make decisions based on information that is incomplete, complex and rather contradictory. This often makes it extremely difficult to see the wood for the trees and can result in bad misjudgements when attention-grabbing aspects of an investment case are allowed to overshadow duller but more important considerations. 

One way to help avoid this is to unpack the judgements that go into an investment decision. A great example of how this can be done was a system designed by a 21-year-old Mr Kahneneman to allocate roles to Israeli army recruits way back in the 1950s. A process he describes as “disciplined intuition”.

Prior to Mr Kahneman’s intervention, assessors made “holistic” recommendations based on a 20-minute interview. Predictions about future success using this process were extremely poor. Mr Kahneman introduced a new checklist-style evaluation system for recruits based on providing individual scores for six key attributes. The scores were then fed into a simple algorithm which made a recommendation. This proved staggeringly effective compared with the old system. It is testament to the power of the 'Kahneman score' that a version is still used by the Israeli military today.

However, one of the most interesting aspects of the system is that to head off rebellion by the assessors, who felt they were being turned into mere box tickers, Mr Kahneman re-introduced a final assessment based on a “holistic” score. As a result of unpacking the important judgements about a candidate before giving a holistic assessment, the assessors’ holistic view went from being demonstrably useless to being the most valuable individual predictive indicator in the new system. The assessors turned out to be right, they did have predictive skill, but they were only able to realise it after considering all the salient factors on their checklists.

At the Investors Chronicle we have spent the past year and a bit using a system very much like Mr Kahneman’s to unpack the thinking that goes into our tips. We want to share some of what we are doing with readers and will be doing this in coming weeks with a new graphic accompanying each article. We’ll give more explanation of the changes at the time they’re introduced. 

This type of process also provides a good format for recording the reasoning behind an investment decision on paper to both clarify thought and for future reference. Mr Mauboussin refers to this unpacking process as a Mediating Assessments Protocol (MAP) and has a very neat way of breaking down what is involved, as set out (in a nutshell) below.

In a nutshell

  • Define in advance the attributes to assess something
  • Gather facts to evaluate on those criteria
  • Make a final decision only after all assessments are complete and scored

 

STEP 5: Nudge nudge, think think

Investors often know what they should be doing; the trouble is, they don’t do it. This can be because emotions dominate in the heat of the moment, but poor implementation can also simply boil down to the fact that following a process can seem dull. That’s despite the fact that a well-designed process can create extremely interesting and profitable insights. 

Ms Flynn Levy’s company, Essentia Analytics, uses machine learning to analyse data from clents' proftfolios in order to identify their strengths and weaknesses. However, the magic sauce for her clients is that they are provided with appropriate reminders to encourage them to act based on the analysis. In behavioural science these types of reminders that are designed into a process are often referred to as nudges.

Ms Flynn Levy’s consultancy provides both 'asking' and 'telling' nudges. 'Asking' nudges are the checks put in place at the time an investment decision is made. This could be a reminder to decide on the desired size of a particular investment or to note what events will be used to monitor the investment’s success. 'Tell' nudges represent a prompt for a review. This could be as simple as a reminder that it is time to rebalance a portfolio with fixed allocations, or it could be a reminder to review an individual holding to check it still deserves its place in a portfolio.

While most private investors may struggle to capture the power of big data to analyse their portfolios, there’s nothing to prevent the adoption of well-thought-out and simple nudges. In the main, notes in a diary are enough, along with a set of rules that are followed when key decisions are made (buying or selling a share for example). Digital diaries can be especially useful in prompting reminders.

The quality of nudges will be improved by understanding one's own investment strengths and weaknesses, which brings us onto step six. 

In a nutshell:

  • Create a checklist for key, recurring investment decisions (see steps one two and four)
  • Set reminders to review and update your investment plans

 

STEP 6: Eat your own feedback

While Essentia’s research does throw up surprises for its clients about their strengths and weaknesses as investors, many of the insights are issues that they are already aware of. The real power of the data analysis is often simply to provide hard numbers that convince them to act. 

It is alway easy to put off addressing a problem in the absence of good feedback. While the importance of luck in determining investment outcomes means the feedback from investment performance is pretty poor, investors who write down what they are doing based on the methods set out in steps one to five will create an invaluable resource for review.

“People get lucky all the time,” says Ms Flynn Levy. But it is much better to understand when you get it right. Did you follow a good process? If you did, can you capture that process?”

The fact we find it so hard to identify and address the strengths and weaknesses of an investment process unless we are confronted by them in an unequivocal way underlines the vital role of step one: ‘Write it down’. 

When reviewing investment decisions, as well as looking at the original reasoning, it is important to write a brief postmortem. Ms Flynn Levy suggests postmortems should break investments down into four basic categories: good decision, good luck; good decision, bad luck; bad decision, good luck; bad decision, bad luck.

To distinguish between quality of decision and luck, Mr Mauboussin's straightforward method to record investment decisions using probabilities from step two is really useful.

In a nutshell:

  • Review your investment rationale
  • Perform an investment postmortem (regardless of whether the investment did well or badly)

 

STEP 7: Persistent practice makes perfect

In the literature on behavioural finance there is one conclusion that is hard to escape: investors should establish a good process that resonates with them and then persist with it. This is a message that has been reinforced by recent research by Philip Tetlock and colleagues, which is the subject of our Further Reading article this week. The research found “noise” (random error) rather than “bias” (error in a particular direction) was the biggest source of forecast error. Importantly, techniques commonly used to counter bias are also extremely effective at dealing with noise because of their focus on structure and consistency. Practice is also a key ingredient in improving the quality of decisions and forecasts.

“[A lot of these] things are simple but not easy,” says Mr Davies. “They’re simple things to understand but they're not easy to enact because we're emotional.”

In a nutshell:

  • Practice steps 1 to 6
  • Persist with steps 1 to 6