Making the Right Decision
The Financialist • Issue 99 • October 2008
BY BRETT SIMPSON BComm CLU ChFC CFP
It is natural to want the easy path to financial security and freedom of choice. It is hard to recognize that our own behaviors lead us astray. Behavior can be more important than investment performance in building and preserving wealth. To develop an investment process that overcomes the factors that distort judgment, we must recognize destructive behaviors in our decision-making and under which circumstances they arise.
Let’s suppose you have an investment decision: “Should I sell, or shouldn’t I?” We all rely on three tools: logic, emotion, or cognitive illusion. One will dominate and determine your decision and behavior.
When logic is foremost, your focus will be on facts and their cause and effect. Logic usually prevails when we decide from a state of emotional equilibrium or control. For example, historical facts tell us that investing in businesses (stocks) will produce the highest long-term benefit. Yet when we examine investment cash flows into stock funds, the pattern is illogical. Investors, overwhelmingly, sell when the markets are down and buy when the markets are up. Logic is not driving these decisions.
If we become overly negative, say, after a market downturn, our loss of emotional control can become extremely motivating. Investors feel the need to take action, intending to regain control. Our stress surrounding short-term circumstances prevents us from carrying through on our longer term financial plans. The stress investors feel is often fear. It is an anticipatory emotion, intensified by uncertainty, lack of control, and feeling responsible for the outcome. When fear is subconsciously a factor, our “feeling brain” (sub-cortex) takes an automatic shortcut to avoid danger, pain or loss. Unfortunately, the shortcut bypasses the “thinking brain” (pre-frontal cortex) where evaluative judgment and motivation for opportunity take place. This emotional distortion of judgment prevents us from making rational decisions based on the expected value of an outcome. Instead, an investment that was doing well, but suddenly dropped in value, is sold (or new deposits are diverted) as a way to regain control.
Emotional decision-making is overwhelmingly damaging to investor returns. Table 1 shows that staying invested, ignoring news and trading less all lead to better returns. When emotions combine with cognitive illusions to support decision-making, the inevitable reality will not conform to our unrealistic expectations. Table 2 illustrates this ill-fated process. Understanding our process of cognition and six of the common distortions can help minimize damaging behavioral investment mistakes.
Over-optimism and Over-confidence can be problematic when investors feel they can predict the future. They trade more and under-diversify, leading to poorer performance.
Mental Anchoring establishes a false or inappropriate baseline for an investor’s future expectations. An anchored return expectation, or sale price, might be based on a recent trend, or even dissimilar assets. Neither is realistic.
Faulty Intuition leads investors to see patterns or predictability in events that are random or poorly understood.
Attention Response is the tendency to overestimate the frequency or severity of an event based on recent exposure to it. News watchers consistently underperform regardless of whether the news is good or bad.
Myopic Loss Aversion causes tunnel vision and excessive risk avoidance. Small setbacks loom larger than they should in the context of overall wealth and time horizon.
Hindsight is an illusion of control that leads to inappropriate risk-taking, or regret and disillusionment over a path not taken. In reality, investors can not accurately reconstruct their prediction of the probability of an event after it has occurred. “I always knew it was true” is a deception as they honestly exaggerate their earlier estimate of the probability. Over time, their collection of hindsight biases clouds judment. We know that emotion and cognitive illusion lead to poor investment results. Consistent out-performers have an expected value mind set, a high degree of awareness of the factors that distort logical judgment, and a focus on process and plan. Your financial advisor can help you stay on the path less traveled.