How We Can Improve Our Investment Decisions
Largely in his own hand, here are the key takeaways from Shane Parrish’s keynote presentation at Pender’s recent Value Investing Conference in Vancouver.
One of the most common things people ask me is how we can improve our investment decisions? Better decisions are a function of two things that sometimes conflict: making fewer mistakes and having better insights. You should walk away from this session with a mixture of both practical application as well as a flexible framework.
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Relevant Thought Processes
When Charlie Munger was asked the secret to his success, he responded “I’m rational.” But what does it mean to be rational?
“The best kind of thinking which we shall call rational thinking, is whatever kind of thinking best helps people achieve their goals.” Jonathan Baron
In investing as in life, there is perhaps nothing more useful than developing thought processes that help determine what is true and what is best to do, and that lead to rational action and belief.
In order to take actions that fulfill our goals, we must base those actions on beliefs that are properly calibrated to the world. We all want our beliefs to align with the way the world actually works and we also want to maximize the chances of achieving our goals, based on the resources at our disposal.
We tend to think of emotion as the enemy of rational behavior and that removing emotional biases from our decision making process will make us more rational. However, while emotions can impede rational decisions, they can also facilitate them. Emotions serve a valuable role because they help us focus.
“… emotions stop the combinatorial explosion of possibilities that would occur if an intelligent system tried to calculate the utility of all possible future outcomes. … In short, emotions get us in the right ballpark of the correct response.” Keith Stanovich
But we often have patterns of behavior that cause us to fall short on rational thinking.
One way of looking at this is that our brains have two ways of reacting. One is an automatic mode. This is when our minds, without thinking, have an immediate reaction to a situation with little or no conscious effort.
This is how we evolved. This is our instinct. I don’t have to think very hard when I see a lion coming at me. I quickly respond to the situation in order to maximize my odds of safety. Academics call this System One thinking.
System Two thinking is when we allocate our scarce resources of attention and effort to mental activities in order to (hopefully) make better investment decisions. We must pay attention or we are likely to end up behaving in a way that is not rational. That is, in a way that fails to acknowledge how the world works, or failing to use the tools at our disposal in the best way possible to achieve our aim.
If we believe the premises that mental resources are scarce and we require these resources to make decisions, it stands to reason that when it comes to searching for a reason to do something our brains shut off when we see an idea that we think fits. We stop thinking because thinking is resource intensive and our bodies are designed to conserve resources.
So this has some interesting implications for decision making. Rather than trying to eliminate these innate biases, a better way is to develop mental models.
Most of us make decisions in an environment where it is very hard for us to behave rationally.
I’m hard pressed to imagine an environment less conducive to rational decision making than that of the modern office worker. It is hard to make rational decisions in this pressured environment.
Now picture Warren Buffett sitting at his desk with his feet up and reading. Look at his empty calendar. He has no meetings and he doesn’t even have a computer in his office. He’s in Omaha for a reason.
“It’s very easy to think clearly here. You’re undisturbed by irrelevant factors and the noise generally of business investments. If you can’t think clearly in Omaha, you’re not going to think clearly anyplace.” Warren Buffett
Buffett is smart enough to structure his environment to reduce decisions, interruptions, and encourage focus.
Our routines influence our decisions as well. One of the objectives of good decision-making is to ensure that decisions are not influenced by irrelevant information.
“I’m trying to pare down decisions. I don’t want to make decisions about what I’m eating or wearing. Because I have too many other decisions to make.” Barack Obama
The President consciously removes the day-to-day problems that absorb people because he has found that he needs to focus his decision-making energy.
“The most successful people don’t have super-strong willpower when making decisions. Rather, they conserve their willpower by developing habits and routines, so they reduce the amount of stress in their lives. … The more choices you make, the harder they become. To save energy your brain starts to look for shortcuts. One shortcut is to be reckless and act impulsively (rather than rationally). The other shortcut is to do nothing, which saves as much energy as possible (and often creates bigger problems in the long run).” Roy Baumeister
If you agree with that then it impacts how you organize your day. You may decide to meet clients in the morning as you know that later in the day, they (and you) are likely already at a point of “decision fatigue”.
Circle of Competence
“You don’t have to be an expert on every company, or even many. You only have to be able to evaluate companies within your circle of competence. The size of that circle is not very important; knowing its boundaries, however, is vital.” Warren Buffett
It’s a simple concept: Each of us, through experience or study, has built up useful knowledge on certain areas of the market. We do not necessarily need to understand the more esoteric areas to invest capital. Far more important is to honestly define what we do know and to stick to those areas. The circle can be widened, but only slowly and over time. Mistakes are most often made when straying from this discipline.
If you cannot understand the variables that govern a given situation you are probably outside of your circle of competence. Ideally you’d pass this decision off to someone for whom this is inside their circle of competence. But what can you do if you are outside your circle of competence and have to make a decision quickly?
Carl Gustav Jacob Jacobi, the German mathematician said, “invert, always invert” recommending that “many hard problems are best solved when they are addressed backward.”
This model is one of the most powerful thinking habits we can adopt. “Indeed,” says Charlie Munger, “many problems can’t be solved forward.”
Think about what makes life good. Now invert the process and think about what would make life bad. Knowing what would make life bad gives you a shortlist of what to sidestep. Both thinking forwards and thinking backwards can result in action, however, despite your best intentions, thinking forward can in fact increase the odds that you’ll cause harm, while thinking backwards is actually less likely to cause harm – call it the avoiding stupidity filter.
As participants in the financial industry, offering guidance, advice, and opinion to clients, your product is decisions. So you should care enormously whether you’re providing good advice or bad advice, and continuously looking for opportunities to learn.
The key to providing good advice is to have a good process. Ultimately, the process matters more than the outcome because the outcome doesn’t always tell you if you made a good decision or a poor one.
If you have a good process and a good outcome that’s deserved success. If, however, you have a good process and a bad outcome, that’s what I call a bad break. If, on the other hand, you have a bad process and a good outcome, that’s just dumb luck. And finally a bad process with a bad outcome is really just poetic justice.
When asked how we can improve investment decisions, Daniel Kahneman, one of the preeminent psychologists in the world who won a Nobel prize in economics, said, without hesitation, buy a very cheap notebook and start keeping track of your investment decisions: A decision journal.
The basic idea is that whenever you’re making a decision of consequence you should write down what you decided and why. Perhaps you want to do this with your clients, ask them these questions as they are making an investment. It could facilitate great future discussions, regardless of whether the investment is a success or failure.
Conceptually, this is pretty easy but it requires some discipline and humility to implement and maintain.
The long and short of it is: In your decision making, spend less time trying to be brilliant and more time trying to avoid obvious stupidity. Avoiding stupidity is easier than seeking brilliance.
PenderFund Capital Management Ltd – www.penderfund.com
© Copyright PenderFund Capital Management Ltd. All rights reserved. November 2014.