Foundations of Behavioural Science 

Behavioural science and successful investment practice

We recommend the following principles to help overcome the behavioural biases that detract from successful wealth management.

1.Learn to embrace uncertainty

In most situations, there are some easy and effective ways to reduce financial uncertainty. These should be pursued. Thereafter, the cost and time required for further reductions begin to increase (disproportionately). At some point, the scope for reductions is exhausted or come at such a cost that they're not worth pursuing. You are left with a core level of financial uncertainty that cannot be dissipated.

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Your choices for dealing with the residual financial uncertainty are to either:

  • Ignore it (and act as if it doesn't exist);
  • Avoid it (and procrastinate); or
  • Accept it (and act rationally based on a long term plan).

All good investors choose the latter approach and apply the following principles:

  • They always invest with rules. Rules that are set in advance and form the basis for decision making under uncertainty. Having a clearly articulated investment policy statement is a useful tool to spell out these rules;
  • They show the discipline to act according to their rules. This can often be quite difficult in the heat of the moment. One of the more important roles of an adviser is to help clients "pull the trigger";
  • They diversify their exposure widely across and within asset classes;
  • They have a clear decision making process. For more information, go to Elements of a Decision Making Process.

To become a good investor, you need to learn to embrace uncertainty. Most people need a strong sense of reassurance before making a long term commitment. It is the role of a quality financial adviser to help you make that commitment by clarifying your future and what needs to happen for you to be successful.

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2. Avoid focusing on the short term movements in your portfolio

What time frame do you wish to judge your performance over? In most situations in life, the more frequently you receive feedback the better you are able to adjust and improve your performance. Investing, however, is not one of those situations.

What makes investing different?

Over the long term, capitalism rewards risk-takers and share markets trend upwards. In the short term, however, markets move in a random fashion. Randomness is counterproductive to good feedback. This randomness or ‘noise’ needs to be stripped out in order to be left with the meaningful feedback.

Unfortunately, the more frequently we observe the market, the more parts of 'noise' we encounter. In addition, distinguishing between noise and relevant data is almost impossible. For this reason, frequent assessments of your portfolio are not very helpful, and are really more a hindrance.

As psychologist and Nobel laureate Daniel Kahneman states:

"If owning shares is a long term project for you, following their changes constantly is a very, very bad idea. It is the worst possible thing you can do, because people are so sensitive to short term losses. If you count your money every day, you'll be miserable."

Warren Buffett, arguably the world's best investor, describes his attitude to investing as follows,

”I never attempt to make money on the stock market. I buy on the assumption that they could close the market the next day and not reopen it for five years.”

We think that most people would rather win the war, even if it means losing a few battles, than end up losing the war by attempting to win every battle. As a good investor you need to be able to cope with losing a few battles in order to win the war. The best way to do this is to avoid focusing on the battles (the short term) and keep your eye on the main game of winning the war (the long term).

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3.Look at the big picture

The broader the picture and the longer the time frame you incorporate into your wealth management decision making, the better the decisions you are likely to make. Without a “big picture” perspective, it is easy to become side tracked and overwhelmed by what are relatively minor isolated concerns. It is a case of not being able to see the forest for the trees.

Effective wealth management decisions require the dismantling of any artificial or notional boundaries you have placed around your financial affairs (see mental accounting) and planning ahead as far as possible (see framing). Invariably, time and cost savings result and, more importantly, potential future opportunities and problems are revealed.

Taking a “big picture” perspective helps avoid the tendency to compartmentalise assets and strategies, and to avoid focusing on individual gains and losses rather than changes in your overall wealth. This results in more effective, and often less complex, solutions.

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4.Avoid being over-confident

One of the most damaging behavioural biases is that of over-confidence. Unfortunately, it is very difficult to accept that there may be things that you haven't considered when the trait of over-confidence is at play. It is difficult for others to assist those who are displaying signs of over-confidence and it is often only through self-awareness that you are able to overcome this trait.

“The more I learn, the more I realise how little I know. The more I realise how little I know, the more I learn.”
- Albert Einstein

When making investment decisions, we recommend that you act with a little humility and caution. It’s important to remember that for every action your take in the market there is someone taking the opposite side. In other words, for every buyer there is a seller. What do they know that you don’t know?

The best way to overcome over-confidence is to employ a sound decision making process. Go to Elements of Decision Making for more information.

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5.Don’t look back

Financial decision making is a forward looking activity. While learning from the past is encouraged, there is nothing to be gained from judging or regretting a decision in view of information that became available after the decision was made.

A focus on the past or what may have been can result in unhealthy self criticism or a desire to blame others for the outcome. Regardless, it is not conducive to progress.

When disappointing outcomes occur despite well made decisions, we encourage you to start with the proverbial “blank sheet of paper”. Forget where you came from and accept where you are. What is the best decision you can make now, based on what you know now. Often the process serves to highlight that the outcome of the previous decision that you now regret was not due to flaws in your thinking but factors out of your control.

To avoid the damaging feelings of regret we encourage people to learn to make decisions with a forward looking attitude. This may not come naturally. However, with practice it will make you a much better investor.

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6.Learn to think independently of the crowd

“A public-opinion poll is no substitute for thought.”
- Warren Buffett

Our natural tendency is to stay with the crowd. It's easier and more comfortable in the short term, but it doesn't always help you to achieve the long term outcomes you desire. Thinking and acting independently of the crowd does not mean taking a contrarian view. We advocate that you make decisions relative to your own clearly articulated objectives rather than relative to external objectives, such as what your peers may be striving for.

To overcome this tendency to unthinkingly follow the herd, we recommend you spend the time to become clear about your long term objectives. A good financial adviser recognises the value of this function. An independent thinking adviser will also help to keep you on track towards your objectives and enhance your ability to think and act independently of the crowd.  

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