When thinking about the challenges investors face in the financial year ahead, we naturally focus on economic and market events that can affect asset prices.
We tend to forget that the future is unknowable and construct plausible and detailed scenarios to describe the cause and impact of those events. We find it easy to list the main risks facing investors and may adjust our portfolios to combat those specific risks.
As we do all this, we often forget that the main challenge facing investors comes not from the economy or the market but from themselves, and specifically the habitual mistakes we make when investing.
This is demonstrated most clearly by our attitude to price volatility. Although sharp price movements can be the enemy of those seeking a stable capital withdrawal, it is a great friend to those saving regularly with a long investment horizon. Despite this, we dislike periods of price volatility and tend to perceive such situations as a threat. This, in turn, can produce a fight, flight or freeze response that overwhelms our ability to make rational decisions and can do far more harm to the portfolio than the volatility we are trying to avoid.
While the weaknesses in our decision making are most obvious in the present, the challenges are even more severe when we think about the future. Faced with the irreducible complexity of what lies ahead, we seek certainty, preferring the vivid forecast to the more boring probabilistic approach.
We find it easier to imagine a future where the action of the central bank is followed by predictable moves in asset prices than to picture a range of possible outcomes detached from a causal event. We consequently overweight the unlikely ‘vivid’ event with the well-structured narrative and underweight the probability that the future will most likely be similar to the past. This can lead to serious investing mistakes.
To make things worse, our bias towards vivid outcomes is only one of dozens of cognitive biases to which we are vulnerable. Each of these can provoke poor decisions that can lead to poor returns, ultimately impairing the financial security of those we serve as advisers and portfolio managers. These biases have been well recognised by behavioural scientists for decades, most famously in the work of Daniel Kahneman who wrote the excellent Thinking Fast and Slow more than a decade ago.
However, unlike the fluctuations of market prices, the risks posed by poor decision making and the impact of these decisions are less visible and therefore easier to ignore. In fact, we are often insulated from confronting the mistakes of the past by the fact that we tend to remember the decisions that turned out well and forget those that turned out poorly regardless of the underlying quality of those decisions.
Annie Duke refers to this as "resulting" in her excellent book Thinking In Bets. By judging the quality of the decisions we make by results of an activity that involves luck, such as short-term investment returns, we prevent ourselves from receiving the feedback that will help us improve. We not only make many mistakes, but we make the same mistakes continually.
