Should you trust your own judgement when investing?
Most investors and dart players miss. But simple behavioural nudges can help improve our accuracy so that we’re more on target.
Take economist Richard H. Thaler’s oft-cited example of the urinals at an Amsterdam airport: Patrons were making a mess. Their aim was off. Why? Maybe they were distracted, tired, or simply careless. They weren’t directionally challenged, but their failures were embarrassing — and easily corrected.
As Thaler recounts, an economist developed a simple fix: etching a small black fly into each urinal. Now that patrons had something to aim at, ‘spillage’ decreased by 80%. Thaler’s book, Nudge, which he co-wrote with legal scholar Cass Sunstein, discusses these types of behavioural conundrums with insights on how seemingly irrelevant details influence and alter everything we do.
Thaler reviewed many of our behavioural frailties during his lively and engaging presentation at the 70th CFA Institute Annual Conference in Philadelphia. The key takeaway: If only we could learn.
He reminded the audience how counterproductive we can become in everything we do. Our innate irrationality coupled with a lack of adequate expertise lead to sub-par, amateurish outcomes. Yet we remain overconfident in our abilities, with often unpleasant results: From choosing the wrong career to failing to save for retirement, our choice pathways remain strewn with predictable errors.
The fallacy of intervention
Some of these errors, Thaler noted, like the decision to intervene, are pervasive and stand out for their disappointing outcomes. When things are going badly, we feel an irresistible urge to step in. The logic, on its face, is flawless. Things are not working right, so it’s time for us to make changes.
But we tend to misconstrue causality, misunderstand our competence, and implement changes that, more often than not, lead to failure.
The illusions of skill, validity and a web of other biases muddle our judgement. Active fund management offers important insights on interventions. Understandably, active management has faced a difficult time. More than 10% of hedge funds close every year. Investors’ innate bias towards discarding underperformers makes the difficult job of active investing all but impossible.
Thaler’s advice? Use processes and well-deliberated algorithms to handle successes and failures.
Behavioural finance makes it clear that human activity, by its nature, is permanently constrained in its ability to optimise decisions. We are not maximisers. We need help, especially with complex choices and in endeavours that require us to exercise control over our biases. Without access to expert thinking, our mistakes will recur. Our record of overcoming behavioural challenges is weak.
That means correcting for irrationalities is the wrong approach.
What does Thaler recommend investment decision makers do instead? Generate returns by building a better understanding of the biases and tendencies of everyone involved.
Courtesy Newsrep