In your blogpost ‘Immeasurably Important’, you talk about the key role of emotions in investment decision-making. Can you elaborate?
Investing is typically taught, particularly at schools, as a mathematical-based field driven by formulae, spreadsheets and numbers. All that stuff is very important. But none of those is going to matter unless you have controlled your emotions.
You can be the smartest analyst in the world — the best at spreadsheets and formulae and math. But if your emotions are going to cause you to make rash decisions or lose control over greed and fear, none of that stuff matters. I think emotions are not only important, they pre-empt all of the other knowledge that takes place in finance.
What are your thoughts about neuro-investing?
It’s a fascinating field and there has been a lot of work on it. Jason Zweig of The Wall Street Journal wrote a great book called Your Money and Your Brain . It’s interesting, but I don’t know if it’s terribly practical.
I think most of the practical stuff that’s going on in behavioural finance is less about chemical reactions in the brain, but more about what you can do as an investor to control your emotions.
I think understanding the neuro side is important in terms of understanding what’s going on inside your head.
But I think behavioural finance takes a practical leap forward once it moves to “OK, so what can I do about this. How can I understand my own biases in a way that will help me make a better decision?”
How can ordinary investors address emotional biases?
With most investors, a lot of the emotions can’t be controlled. I think what’s important is understanding yourself and getting to know yourself. So that if you have a propensity to be greedy or fearful, you understand that and you set up your investing strategy and asset allocation in a way that it is going to be realistic about your own personal flaws.
A big problem in investing is that advice and recommendations are often put forth in a kind of one-size-fits-all fashion. In reality, what works for one person may not work for another. That’s why investing is a very personal endeavour where you need to understand your own flaws and biases and set up your investing strategy around that.
There is a school of thought that in investing, simple is better than complex, and that one should apply heuristics. That could be contradictory to prescriptions to control emotional biases. Your thoughts?
I think complex investing strategies are not necessarily bad. There are a lot of complex investing strategies that certain investors and hedge funds have done very well with. But I think the more complex your strategy is, the more opportunity you are giving yourself to inject bias into your decision-making process.
The more knobs you have to fiddle with in your portfolio, the more opportunities you are giving yourself to screw up. By taking a simplified approach to investing, you are more or less reducing the number of decisions that you have to make. And when you reduce the number of decisions you have to make, you are upping the odds of removing bias from your decisions.
What, in your view, is the key problem hindering effective investment decisions?
I think probably the most important is underestimating the amount of time it takes for good investing results to accrue to you in a way that you can be confident it is not attributed to luck. If you ask investors, most say they are long-term investors. But then a lot of them say that long-term is one year or two years or maybe five years. I think it is at least 10 years, if not 20 years or more.
A lot of investors do have a timeline of 10 or 20 years if you are saving for retirement or something like that.
But how they analyse the market in their investing decisions is rarely based on time horizons that are that long.
Very often, we get attracted to short-term performance. The shorter the time period to consider outperformance, the higher the chance of it being attributed to luck.
How about emotional biases such as overconfidence and herding?
I think it’s probably a bigger factor today than ever because of social media. It gives investors more opportunities to find someone else or a group of people who agree with them.
Then, confirmation bias sets in and it snowballs from there. When you have a system like that when biases become shared and you see other people who agree with you, you get more confident and get ingrained in your own views. You are more likely to double down on that strategy. It’s tough to overcome this because the feeling that you get from people agreeing with you is great. You suddenly feel like all these feelings you had are justified.
How do investors address this bias?
I have always believed is that if you have a view on the stock market or a company or the economy, it is incumbent on you to be able to explain the opposing side’s view as well as they can.
So, if I say that we are not going to have a recession next year, I need to be able to understand the views of those who say that we are going to have a recession next year, and able to explain their views as well as they can.
And if I can’t do that — I can’t explain the opposing side’s view as well as they can — it increases the odds that I am just living in my own thought bubble and not taking a much broader, more holistic view of the world and what else is going on there.
Because the opposing side’s view might very well be just as smart as mine and may have just as information as me. If they came to a different conclusion, it just might be that they have a different perspective that I am not aware of.