Invest in a diversified portfolio, rebalance occasionally, ignore short-term market movements and allow your returns to compound over time – investing seems like a simple game but, as Warren Buffett often points out, it's not an easy one. Could something as simple as a checklist make the game an easier one to play? Six steps – three dos and three don'ts – can help improve investor decision making, says Aberdeen Standard Investments fund manager Joe Wiggins, who has written a behavioural finance toolkit highlighting common investor mistakes. The steps are simple:
- have a long-term investment plan;
- automate your saving;
- rebalance your portfolio;
- don’t check your portfolio too often;
- don’t make emotional decisions, and;
- don’t trade. Echoing Buffett, Wiggins admits the steps “seem simple but are not easy”. Why? A multitude of inbuilt unconscious biases undermine investors’ decision-making, resulting in a behaviour gap between how we should invest and what we actually do.
"Closing this gap is difficult," says Wiggins. "Logic points in one direction and the human mind in another," with the "unpredictable nature of financial markets" seemingly designed "to lure us into errors of judgment". Wiggins argues that we cannot remove our biases; rather, we must build an investment process that helps us overcome them, which is where a checklist comes in. He refers to The Checklist Manifesto, a book written by US surgeon Atul Gawande, who developed a simple, safe surgery checklist for the World Health Organisation that was applied around the world with "staggering success".
Checklists encourage consistent behaviour and thereby limit mistakes, argues Gawande.
Mirrors checklist
Wiggins’s checklist, titled Mirrors, addresses the behaviours that create the aforementioned behaviour gap.
“M” stands for myopic loss aversion, a term used by behavioural finance experts to describe the fact that people are inherently more sensitive to losses than to gains. Countless studies have found the pain you experience when you lose money is much greater than the joy experienced when you gain an equivalent amount. Consequently, investors often struggle to cope with short-term losses, says Wiggins, even if these losses are irrelevant in the context of long-term goals.
Loss aversion means some investors take too little risk or avoid stock markets entirely; others focus on irrelevant short-term movements and check their portfolio too often. One study found that investors who receive the most frequent feedback took the least risk, notes Wiggins. He says investors should check their portfolio no more than once a quarter or even once a year.
There is no better setting to help us understand herd mentality than financial markets'
Some “gentle nudges” – for example, setting a password for your investment account that takes a degree of effort to retrieve – can help investors in this regard. The “I” in Mirrors stands for integration, people’s tendency to conform to group behaviour. There is “no better setting to help us understand herd mentality than financial markets”, cautions Wiggins, warning that basing your decisions on the behaviour of others fuels bubbles and crashes. “R” stands for “recency”, investors’ tendency to pay too much heed to the importance of recent events. During strong bull markets, positive economic and corporate news can cause investors to forget the lessons of history and to assume the trend will continue indefinitely: for the same reason, negative recent news can make investors reticent to invest near the bottom. Decisions can be “swayed by the most recent news headlines, even when making long-term decisions”, writes Wiggins.
Risk perception
R also stands for risk perception. Humans are poor at assessing risks and probabilities. Studies show we overestimate the odds of winning the lottery. When betting on horse racing, the longshot is overbet and the favourite is underbet. At the same time, investors pay too little heed to certain low-probability events, failing to insure against catastrophes like floods and earthquakes.
Investors exhibit “probability neglect”, says Wiggins. Decisions should be driven by a careful assessment of the odds; instead, they are often affected by how readily an example comes to mind.
Studies indicate there are three particular types of overconfidence
Separate research by Nobel economist Robert Shiller bears out this point. Surveys he conducted show that, on average, investors estimate the odds of a catastrophic one-day crash over the following six months to be around 19 per cent, when the reality is such crashes are extremely rare, occurring in just 1 per cent of all six-month periods. Investors get the odds wrong simply because such events come easily to mind and are not easily forgotten, thereby distorting their risk perception. "O" stands for overconfidence, that most dangerous of investor vices. Studies indicate there are three particular types of overconfidence, says Wiggins, namely that we overestimate our own performance level.
We believe we are better than others (for example, surveys show almost everyone thinks they are an above-average driver and almost all fund managers believe they are equal or better than their counterparts) and we believe we know the right answer (ironically, one US survey showed eight out of 10 people were concerned about government debt levels, though a separate survey in the same year showed the same number didn’t know how many millions are in a trillion).
“Overconfidence can create costly problems for investors, such as insufficient portfolio diversification and overtrading,” says Wiggins. “Our confidence can tempt us into short-term trading, despite the challenges of anticipating the moves in volatile and often random markets. It is important to be humble in our investment decision-making.” The third “R” in Mirrors stands for results – the fact that investors tend to judge a decision by its eventual result instead of the quality of the decision. The reality is that good decisions (for example, avoiding dotcom stocks in the late 1990s) can sometimes lead to bad outcomes, just as bad decisions (say, investing in cryptocurrencies on the basis that your neighbour made a bundle by doing so) can sometimes lead to good outcomes. “S” stands for stories. “We are persuaded by compelling stories.” says Wiggins, using them to explain and simplify the randomness of markets.
Simple stories allow us make sense of complex issues, but this can leave us vulnerable to poor investment decisions. A headline such as “Stocks rally in Europe and Asia ahead of trade talks” is less accurate than one saying “Stocks fluctuate due to normal random movements”. Simplistic and changing narratives can lead investors to trade too often, he warns.
No panacea
The Mirrors checklist is not a panacea, but asking some key questions prior to making a decision can help, says Wiggins. Am I reacting to short-term losses? Am I just joining the crowd? Am I paying too much heed to recent news stories? Have I carefully weighed up the odds? Am I being overconfident? Would I be making the same decision if recent results were different? Is a captivating story influencing me?
These are good questions, but investors must ensure a checklist is more than a box-ticking exercise, says hedge fund adviser Adam Robinson. In a recent discussion with Farnam Street blogger Shane Parrish, Robinson described Atul Gawande's checklist research as "brilliant" but noted that almost 600 lives were lost in 1977 in the worst aviation disaster in history. Why?
Right before he crashed into another plane on the ground, the pilot was “racing through a checklist”.
