Investors: Learn to Make Better Decisions

By
Paul Craven, ASIP, director of Salomon Partners

The 2016 CFA Institute Middle East Investment Conference will take place in Bahrain on 13 April 2016, bringing together international thought leaders, policymakers, industry experts and key market participants from across the region to consider MENA’s Role in the Global Economy.

Behavioural finance adds value by combining psychology with economics and helping investors make “conscious, logical, and rational” decisions, said Paul Craven, a behavioural finance coach, at the 2015 CFA Institute Middle East Investment Conference in Kuwait. He believes there are practical measures investment professionals can take to address their behavioural biases.

Quoting Nobel Prize winner Daniel Kahneman, Craven explained that we are all prone to using faster and instinctive thinking (System 1 thinking) even in situations when we really should be employing slower and analytical thinking (System 2 thinking). When the price of oil is at a record high, investors feel bullish about it, and when it hits a record low, investors feel bearish about it. Craven said this is an example of employing System 1 thinking when we should really be using System 2 thinking — rationality demands buying low and selling high, not the other way around. Craven cited legendary investor Benjamin Graham: “With every new wave of optimism or pessimism, we are ready to abandon history and time-tested principles, but we cling tenaciously and unquestioningly to our prejudices.” When most investors are feeling euphoric, clinging to their prejudices, it’s the point of maximum risk, not opportunity, added Craven.

At precisely which point investors feel euphoric can be hard to pinpoint, but, Craven stated, it is hard to deny that it happens. He added that investors are prone to suffer from behavioural biases en masse, and using the research of Jean-Paul Rodrigue from Hosftra University, he showed that the technology bubble, housing bubble, and commodities bubble had similar patterns. Craven believes this testifies to what Mark Twain once suggested: “History does not repeat itself, but it does rhyme.”

Craven emphasised that as human beings, we are influenced by stories a lot more than data. Pointing to research about our behaviour toward medicine, he argued that a single positive or negative story involving a single data point can be more powerful than lots of data points. He cautioned that the media can be full of stories, which are not necessarily lies but not data, and investors need to remain aware of it.

He proceeded to caution that economists have an unimpressive track record of making forecasts and asked why none of the 62 recessions in 2008–2009 were predicted in the previous year. Craven offered three possible reasons: unreliable economic models; forecasters who are not incentivised to be neutral (but often to be optimistic); and, of course, behavioural biases.

Paul Craven at the 2015 CFA Institute Middle East Investment Conference

Paul Craven at the 2015 CFA Institute Middle East Investment Conference

Craven believes the best investment advice was offered by Charles D. Ellis, CFA: It is not so much about picking winners but avoiding losers. He quoted Ellis: “The victor in a game of tennis gets a higher score than the opponent, but he gets the higher score because his opponent is losing even more points.” Trying too hard to win and going out of your area of strength can cause you to pick losers. Craven explained that Ellis believes investors should keep it simple, concentrate on their defenses, and play their own game. Craven was of the view that Warren Buffett also advocates something similar: defining and staying within your circle of competence. He quoted Buffett: “The size of that circle is not very important; knowing its boundaries, however, is vital.”

What practical steps can investors take to overcome behavioural biases to make better investment decisions? Craven offered five:

  1. Ask yourself: Am I using System 1 or System 2 thinking? Take care not to apply fast and instinctive thinking to what merits much slower and analytical thinking.
  2. To avoid conformity and groupthink in an investment committee, encourage someone to play “devil’s advocate” so that the counterpoint, no matter how unpopular and discomforting, is fully examined.
  3. Learn to distinguish between data/evidence and stories. We prefer stories over data, but it is better to start with data and build a narrative from there, rather than the other way around.
  4. Beware of the role played by randomness and luck in investment decisions and be willing to not attribute to skill what could well be caused by luck.
  5. Record the rational for your decisions in a diary so that you can go back to it and be sure why you favoured a certain decision. This will help you to avoid the “I told you so” hindsight bias.

For those interested in knowing more about behavioural biases in investing and how to correct them, Craven suggested the following books:

  • Extraordinary Popular Delusions and the Madness of Crowds, by Charles MacKay
  • Why Smart People Make Big Money Mistakes and How to Correct Them, by Gary Belsky and Thomas Gilovich 
  • Manias, Panics, and Crashes: A History of Financial Crises, by Charles P. Kindleberger
  • The Optimism Bias: Why We’re Wired to Look on the Bright Side, by Tali Sharot
  • The Success Equation: Untangling Skill and Luck in Business, Sports, and Investing, by Michael Mauboussin
  • Predictably Irrational: The Hidden Forces that Shape Our Decisions, by Dan Ariely
  • Nudge: Improving Decisions about Health, Wealth and Happiness, by Richard H. Thaler and Cass R. Sunstein
  • The Wisdom of Crowds, by James Surowiecki
  • Risk Savvy: How to Make Good Decisions, by Gerd Gigerenzer
  • Thinking, Fast and Slow, by Daniel Kahneman

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Please note that the content of this site should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute.

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