Friday, November 4, 2016

We Are Not Always So Rational, Part 4

A quick recap: In part 1 & 2, we discussed several cognitive & emotional biases that we suffer from, as well as where these biases originated from. In part 3, we looked at the impact of our biases: on ourselves, our portfolios and on the markets.

I had a reader (Nick de Peyster) leave a comment recently that “investing is about 25% knowledge and 75% dealing with emotional and cognitive biases.” I agree.

In this fourth and last post of this series, we discuss ways to minimize the damaging effects of our biases. Other than the post on compound interest, this is one of most important topics in investing. There are a lot of items discussed here and I will likely touch on them again in more detail in the future.

Minimizing the Impact of Our Biases:

1.  Be Self-Aware

Source: hubpages

Managing yourself begins with knowing yourself. We all have a different risk tolerance and different set of behavioral biases. Learn the types of common biases and determine which ones you suffer from. This series of blog posts can be used as a starting point.

Remember, if your biases are mainly cognitive – they can be fixed through education. If your biases are mainly emotional, then read on.

2.   Be Evidence-Based

Source: pinterest

You can be a passive, value, quality or momentum investor – that’s not the point. The important thing is that you prove to yourself with sufficient evidence that your approach is sound and robust. And do not simply rely on conclusions of others. When your strategy is undergoing that inevitable period of under-performance, you are more likely to stick with it if you understand the strategy thoroughly.

It is recommended that you: 
  • Research and formulate a simple strategy. The simpler the better
  • Gather quality data over a sufficiently long time-period, covering different market regimes
  • Perform back-testing to determine if the strategy has significant outperformance while being cognizant of data mining bias
  • Perform stress-testing to check for robustness (eg. are the results highly sensitive to changes in the model’s settings?)
  • Seek out contrary opinions to reduce confirmation bias. Perhaps there is something you missed in your analysis

3.  Be Systematic

Source: clipartkid

We are increasingly seeing the world become more systematic, from computers marking English essays to self-driving cars. As an Electrical Engineer who worked on developing automation products, I think this is a great thing. Machines, if programmed and maintained properly, typically perform tasks with higher accuracy, efficiency and consistency than humans.

So whatever your investment strategy is, it must be systematic. The less you have to think or do, the better. This not only ensures consistency, but it allows little room for your emotions to interfere. 

4.  Optimize For Your Biases

I used to believe that the Sharpe Ratio (ie. risk-adjusted returns) was what you wanted to maximize. I even named this blog after that term. But this approach is only true if we're robots. For humans, choosing a strategy or asset allocation that deviates from the "optimal" (highest SR) is a perfectly reasonable decision if it reduces your anxiety and is something you are likelier to stick with for the long haul.

So even though I believe a systematic trend following approach is the best for me personally, many have emotional biases that will not realize this no matter how much you educate them. For these types, a passive approach may fit their personality better. While not optimal, it is better than not investing at all.

Another approach is to use pyramiding. For many, investing in one strategy (even if it is robust and sound) can be nerve wracking: either too conservative or too risky. They may instead want to layer their portfolio. The majority of their portfolio can be in the optimal strategy, while the rest can either be in something conservative (eg. a 30% allocation to bonds) or aggressive (eg. a 5% allocation to individual stocks). 

5.  Live Healthy

Source: Vegansoceity

Studies have repeatedly shown that nutrition, exercise and meditation are the most effective ways to reduce stress & anxiety, improve sleep and boost self-esteem and energy levels throughout the day.

Nutrition – Most of us skip meals or reach for junk food during times of stress, but this is right when the body has a higher need for nutrients such as vitamin C and many B vitamins. To make matters worse, feeding our sugar craving may give us that quick burst of energy, but it is short-lived and usually followed by an even worse slump in energy (link).

There has been overwhelming evidence demonstrating the power of plant-based foods: greens, fruits, spices, beans, nuts and seeds. And it goes beyond just reducing stress. Dr. Michael Greger, author of the best-seller “How Not to Die,” shows the scientific evidence of how plant-based foods can prevent and reverse the 15 top causes of premature death, such as heart disease, diabetes and high blood pressure. The easiest and most delicious way to incorporate these foods in your day is with a smoothie. A good blender is the best investment you can make.

Exercise – All forms of exercise help the brain release endorphins and serotonin, triggering a positive feeling in the body. One study found that those who exercised at a moderate intensity for 40 minutes, 3-5 days per week experienced the greatest mood-boosting benefits. So get out and go walking, cycling, yoga or doing strength training.

Meditation – Studies have shown meditation to reduce stress, improve your ability to concentrate, lower blood pressure and boost your immune system.

The focus of meditation is to bring you into the present moment, to quiet an overactive brain and even to reflect on things you are grateful for. Sit with a straight back, practice breathing deeply, and try some background sounds. Be patient & committed and you will find over time that your focus will improve. I highly recommend a guided meditation app called Calm (Apple, Google).

6.  Go On An Information Diet

Thanks to our smartphones and social media, we are now bombarded with information more than ever. And not the information found in books or long articles but:
  • Endless social streams with just a few snippets of words at a time
  • Financial apps flashing ticker quotes in real-time from the palm of your hand
  • Financial media trying to convince you that the next crash is around the corner

How can any of that be good for us?

Author Rolf Dobelli has an excellent article titled “Avoid News: Towards a Healthy News Diet.” In it, he talks about how: 
  • News is to the mind what sugar is to the body. It gives us short-term excitement
  • News is toxic – panicky stories spur the release of cortisol which deregulates the immune system 
  • News misleads us, is often irrelevant and even manipulative
  • News makes us passive, distracted, inhibits thinking and kills creativity 

I highly recommend reading Dobelli’s article. Then go on an information diet: turn off CNBC, reduce the apps on your phone and check your portfolio infrequently. You’ll notice you will have more time, less anxiety and deeper thinking.

7.  Have the Right Mindset

“Patience you must have my young padawan” - Yoda

Despite our best laid-out plans, its easy to get caught up in the latest headline and be tempted to override our system. Being firmly rooted in the following beliefs will help:

  • On average, making impulsive portfolio decisions have significantly hurt investor returns (see part 3 of this series). Do not be fooled into thinking it will be any different this time. Any trade decision that is not backed by a logical, evidence-based approach is not worth taking
  • Your ability to stick with a plan is more important than the plan itself
  • Real wealth accumulation happens over the long-haul, through the power of compound interest
  • Stocks have historically been the asset class paying the highest risk premium. Your goal as an investor is to be invested in stocks as often as possible and only switch to bonds through a systematic risk-management process.

8.  Consider A Human Advisor

Source: Carl Richards, The Behaviour Gap blog

A financial advisor’s main job is to prevent you from doing irrational things with your portfolio.

I mentioned in item 3 above that many tasks are now being automated and that this is generally a good thing. One area that recently exploded in growth is the robo-advisor space. And its first real test came this summer during the Brexit craze. You may have heard that industry giant Betterment locked down accounts to prevent clients from irrationally liquidating their portfolios. While this was well-intended, it may not have been as comforting as talking with a human advisor.

What sets a human advisor apart from a robo is their ability to communicate, to listen, to empathize and to care.  This personal connection is more comforting during times of panic.

Human advisors can also help you with item 1 above: to be self-aware. They give you regular risk tolerance questionnaires and personal assessments to help you understand yourself better. They can also help with educating you on any cognitive biases you may have. 

Further sources

There are too many excellent books, articles, podcasts and videos going into detail on the various topics we covered in this 4-part series. Some of the ones to consider are listed below. Enjoy!

  • Thinking Fast and Slow by Daniel Kahneman. Dr Kahneman is a psychologist that won the nobel prize in economics for his work on decision-making. He is considered to be the father of Behavioral Economics, which challenges the assumption of human rationality prevailing in modern economic theory.
  •  Predictably Irrational: The hidden forces that shape our decisions, Dan Ariely. When it comes to making decisions in our lives, we think we're making smart, rational choices. But are we?
  •  Sapiens: A Brief History of Mankind, by Yuval Noah Harari. If you want to know more about how biology and history have defined us, read this excellent book
  • 10% Happier: How I tamed the voice in my head by Dan Harris. The author discusses how he stumbled upon an effective way to rein in the voice in his head, something he always assumed to be either impossible or useless: meditation.  a tool that research suggests can do everything from lower your blood pressure to essentially rewire your brain
  • The Behaviour Gap: Simple ways to stop doing dumb things with money by Carl Richards. The behaviour gap is the distance between what we should do and what we actually do. The author gives great advice on how to prevent emotions from getting in the way of smart financial decisions.

  • You are not so smart podcast by David McRaney. David has done over 80 podcasts, with each episode focusing on a unique behavioral bias. Oh and every episode ends with a cookie recipe, so there’s that.
  • Masters in Business podcast – interview with Daniel Kahneman. Highly illuminating discussion with the father of Behavioral Economics

  • Overcoming Behavioral Biases Through Mindfulness Training by Dr. Ulrich Kirk (CFA Institute, 4th video in the playlist)
  •  Mind over Money, PBS Nova. Explores why we so often make irrational financial decisions and how our emotions interfere with our decision-making. Entertaining!
  • Boom Bust Boom, a documentary that “guides us through the history and the nature of the economic boom-bust cycle and why people repeatedly ignore it to their sorrow” - IMDb


The End. Thanks for reading!