cancel
Showing results for 
Search instead for 
Did you mean: 
     
Highlighted
Explorer ○

6 Ways to Make Smarter Investment Decisions

Here are a few psychological tools that can instantly help you to make better investment decisions.

Distancing

In 1985, Intel has a tough decision to make: expand its core memory chip business that is rapidly losing money due to heavy competition from Japanese counterparts or bet on their nascent but fast-growing microprocessor business. There was plenty of tension between the two factions of the business, both with justifiable reasons that Intel should exit the other business. Andy Grove, Intel’s CEO at the time, then turned to Gordon Moore, founder, and Chairman of Intel, and asked, “If we got kicked out and the board brought in a new CEO, what do you think he would do?” Gordon answered without hesitation, “He would get us out of memories.”

Our emotional attachment can sometimes blindside our ability to make good decisions. Sometimes, we make poor investment decisions not because there’s a lot of uncertainty, but because our emotion prevented us from seeing the obvious solution. So when you have to make a tough decision, adopt the distancing approach as if someone else has to make that decision, and ask “what do you think he would do?”

Thinking from a third-party point of view reduces emotional-driven decisions, and this can be an effective antidote against endowment effects. In Misbehaving, Richard Thaler explains his friend purchased bottles of wine long ago for $10 but is now worth over $100. He drank them on some special occasions but would never pay $100 to acquire them. That’s the endowment effect: we value an object we own more than when we don’t own it. If you own a stock for many years that have done well in the past, it is hard to decide what to do when the company’s future direction becomes less rosy than you’d expected. Therefore, imagining as if someone has to make the decision will give you a pair of fresh eyes by looking at the investment more objectively while avoiding confirmation bias in the process.

Distancing can also be useful when you’re tempted to get into an exuberant market or crowding for the exit door in a market panic. Most investment mistakes happen during the buy or sell stage caused by external factors such as market volatility. We tend to rely on System 1 that is fast, instinctive, and emotional during these situations. Distancing prevents that by letting our System 2—slow, deliberative, logical thinking to take charge and reduce the odds of making silly mistakes. 

 

Ulysses contract

In Homer’s epic poem the Odyssey, Odysseus, the legendary Greek king of Ithaca, is aware of the danger of passing the island of the Sirens. Sailors who get bewitched by the Siren song will steer towards the shore and crash to their death. To avoid that, Odysseus told his sailors to tie him to the mast and cover their ears with beeswax so they could sail past the island unaffected by the Siren song. 

Ulysses contract is a freely made decision that is designed and intended to bind oneself in the future. It is a form of precommitment where you commit to doing certain things in advance. Setting up an automatic regular investment plan is a precommitment. It increases the barrier of making bad decisions because by automating the process, it saves you from having to make and remake the same decision. You know that a fixed portion of your salary will go into an investment before you get to spend it on other things. 

A checklist is a Ulysses contract. If you have a checklist you have to go through before you hit the buy or sell button, that is likely to reduce your chance of making poor impulse decisions. Financial advisors have been getting all the bad rap lately (at least in Australia) from charging exorbitant fees, but it is also reasonable to say that in time of market panic, having to go through your advisor before you can make any buy or sell decision can be positive. He is likely to advise you to stick to the long-term plan by avoiding short-termism. 

What’s even better than having a checklist is to delete the stock market app on your phone. Binding yourself in the past so you have nowhere to check the daily share price means you won’t get panic and make silly decisions. 

Ulysses contract is an exit plan as well. Most people got into an investment without knowing when or under what circumstances they should sell. As a result, the sell decision often gets influenced by the share price’s direction. Which is why almost everyone does the opposite of ‘buy low, sell high’. Ulysses contract can be in the form of setting a limit of how much to put into a stock to avoid overinvest i.e I’ll put no more than $10,000 into this stock. Or it can be a fixed timeframe like “I’ll sell this stock after 12 months regardless of the price.” These contracts prevent us from holding onto a position for far too long either because the price keeps breaking new high or hoping a value trap stock will someday return to our purchase price.

 

Tripwire 

David Lee Roth is the lead singer of Van Halen, an American rock band. In Van Halen’s 1982 world tour, the band had an unusual request stated in their contract: M&M’s (WARNING: ABSOLUTELY NO BROWN ONES). When David Lee Roth arrived backstage, he would make sure there’s no brown M&M’s in the bowl. This turns out to be a smart idea. With a contract as thick as hundreds of pages, it’s impossible to check every single item to make sure the concert promoter has done everything correctly. So no brown M&M’s would act as a tripwire to find out whether the promoter has overlooked some important aspects of the setup. 

A tripwire makes you stop and think. Two common tripwires in investing are:

  • “If the market is close for the next 10 years, would I still buy it?”
  • “Would I buy more if the stock falls by 50% tomorrow?”

Our brain is like that hundred pages contract, it’s hard to know what’s going through our mind when we make a decision. So these questions are like the brown M&M’s that tell you whether you’ve missed something important in your investment process. 

When Warren Buffett suggested investors write down their reasons on a piece of paper “I wanted to buy [numbers] of [stock] at [price] because….”, that’s a tripwire. It makes you stop and think. If you find yourself staring at the blank paper for too long, then that’s a big red flag. Abort the buy immediately. 

A counterintuitive tripwire idea is brokerage fees. Nowadays, most online brokers offer ultra-low fees or even zero fees for trading. What if you get one that charges $200 per trade? That would make you think long and hard before you make a trade. Just as you’ll find more drunk people at a bar that offers free-flow alcohol, there will be more rampant trading when it costs nothing. The $200 brokerage fee has a similar psychological benefit to splashing your face with cold morning water: it clarifies the thoughts and improves decision quality. And this benefit easily outweighs the short-term discomfort of losing $200 (or numbness on the face). 

Another lesson from tripwire is that it is better to spread buys over multiple trades than a single large one. Just as an automatic regular savings plan makes it easier for you to save up because you don’t have to constantly remake the decision whether to save, spreading buys over multiple trades makes it less likely you’ll make a terrible mistake due to a one-off impulse buy by forcing you to constantly think about the reasons of buying. 

 

10/10/10

Before you make a decision, ask “What are the consequences of my decisions in 10 minutes? In 10 months? In 10 years?”

In Thinking In Bets, Annie Duke describes how 10/10/10 can help us make better decisions, “Bringing our future-self into the decision gets us started thinking about the future consequences of those in-the-moment decisions. We are more likely to make choices consistent with our long-term goals when we can get out of the moment and engage our past and future-selves.”

We tend to make bad investment decisions due to short-termism; too much focus on what’s happening at the present, especially when you follow the market. Humans are governed by a simple rule: seek pleasure and avoid pain. We sell during a market crisis because it is painful to watch our investments go up in smoke. This is also called temporal discounting: we favor our present self at the expense of our future self. The solution here is to shift our focus from the present to the future by thinking about what are the consequences of our action 10 months from now and 10 years from now. This changes how we feel about the situation and the decision we are about to make. 

This is not to say selling when the market is down is always the wrong decision, of course. Investment is all about opportunity cost. But the key point is that when we take into account the long-term implication of our actions, we are likely to make a better decision than when we are inundated by what’s happening right now.

Invert

 

“Invert, always invert!”, that’s Charlie Munger’s advice on making better decisions. Similar to the old hag/young lady optical illusion, inversion is a way to flip your thinking by thinking backward and forward. If you want to make good decisions, think of ways to mess things up and avoid just that. If you want to make money in the stock market, ask “How do people lose money?” and do the opposite. Want a company that thrives in hard times? Then, how do you make a company go bust? You saddle it with lots of debts, put it in a cyclical, commoditised industry with a high fixed cost and high exit barrier, and install management who are incentives to fatten their own pockets. Should I buy this stock? Think of all the reasons that will make you sell it, and buy it if you still find the stock attractive. How can you have better self-control and be less emotional in the market? That’s hard to answer. An easier question would be “How to make someone panic?”. Well, you keep him in the dark so he is unprepared and gets surprised easily, makes him sleep-deprived, and flood him with information overload.

 

The Outside View

Eleanor Roosevelt used to say “Learn from the mistakes of others. You can’t live long enough to make them all yourself.” That sums up the outside view. The inside view looks at specific circumstances surrounding a situation, while the outside view ties circumstances to an appropriate reference class by asking what can we learn when others encounter something similar.

We are wired to rely on stories to understand reality. We look for a narrative to explain past success or failure; why some companies succeed while others don’t; or what happened in the market. The inside view is lucid. But it is also dangerous because it is a small sampling of the reality that can easily be distorted by survivorship bias and availability bias.

It is the reason why we tend to be overconfident in the stock market. We overestimate our prediction skills and the growth prospect of a company without considering the response of its competitors. There was an experiment where basketball pundits estimated the chance of their favorite team winning the NBA championship for the season. The outcome wasn’t a surprise. The total probability exceeded 100%.

We shouldn’t dismiss the inside view, of course. It’s just that the outside view gives you an additional benefit of seeing things so you don’t miss the forest for the trees. It is like checking the online reviews of a restaurant, a book, a movie or a product before making a decision. You’re thinking that the experience of the crowd is a good indication of yours. 

How can we apply this to investing and life? Get into situations where the outside view (or base rate) is attractive and avoid unattractive ones. The base rate of success is non-stop learning, refining, and crafting skills. The base rate of happiness is compassion. The base rate of smoking is premature death. The base rate of fewer decisions is better decision quality. The base rate of good judgment is humility, process-driven, and open-mindedness. The base rate of wealth accumulation is to avoid big losses. The base rate of speculation is losses. The base rate of investment mistakes is preventable failures. The base rate of checking daily prices is excessive risk-taking. The base rate of following the market is cognitive biases. The base rate of excessive financial leverage is ruin. 

6 Replies
Highlighted
Participant ○○

Re: 6 Ways to Make Smarter Investment Decisions

This has got to be one of the best posts I have ever read on Morningstar.

Copie

0 Kudos
Frequent Contributor

Re: 6 Ways to Make Smarter Investment Decisions

Great post Dreamxite! 

Win
0 Kudos
Highlighted
Explorer ○

Re: 6 Ways to Make Smarter Investment Decisions

This is an exceptionally well written, entertaining, and informative piece.  Thanks for taking the time to so carefully craft it.

0 Kudos
Highlighted
Participant ○○

Re: 6 Ways to Make Smarter Investment Decisions

I wrote this down a long time ago from someone a lot smarter then me!

The key to long term success is to pick a good strategy and then establish a life time commitment to maintain that strategy regardless of what going on in the market.

Copie

0 Kudos
Highlighted
Explorer ○○○

Re: 6 Ways to Make Smarter Investment Decisions

 

Great, timely post Dreamxite!  

Thanks!

0 Kudos
Highlighted
Frequent Contributor

Re: 6 Ways to Make Smarter Investment Decisions

Behavior science is important to investment since it is totally contrary to human thinkings. 

For me, the most important first-step is to spend a lot of time (reading/learning through useful material such as this piece) to construct a long-term plan (with crucial factors like asset allocation and risk tolerance according to time horizon) and the worst-case strategy.  Then put it into practice to modify/fine-tune this plan (through trial-and-error).  Finally stay the course without any exterior noise.    

Announcements