Summer reflections: Investor decisions

Please note: The article does not constitute advice or any form of investment recommendation. Past performance is never a guarantee of future performance.

The importance of reflection

The summer break can be a good time for investors to review business and investment decisions and performance, and to think about positioning for the rest of the year. 

As well as reflecting on the impact of past events, it’s important to think about one’s reactions to them. This means contemplating both the decisions taken, as well as those not taken, and their impact. Investors are typically better at reflecting on the actions that they followed through with. 

The importance of this reflection is due to the role that investor psychology has in driving markets. Superior investment returns come from understanding the difference between how things are supposed to work, and how they actually do work in the real world. A key input to this difference is psychology.

If understanding investor psychology can help make sense of, and capitalise on opportunities at the market level, then analysing decision-making at the individual level should also lead to better outcomes for the individual investor. This is because of the use of heuristics and the resulting behavioural biases that can impact judgments. 

The role of heuristics

Heuristics are mental rules of thumb that we all use in our daily lives, that help us to simplify decision-making. A prevalent and relevant heuristic is availability – people overweight the importance of things more readily available in their minds, such as dramatic and emotive news. 

To help bring this to life, consider the following question: If a random word is taken from an English text, is it more likely that the word starts with a K, or that K is the third letter?

English speakers will immediately think of many words that begin with the letter K (such as kangaroo or kale), but it takes more effort to think of words in which K is the third letter (for instance acknowledge or ask). As a result, most people will overestimate the number of words that begin with the letter K, and underestimate those with K as the third letter. 

In investing, there’s a similarity whereby people can pay too much attention to events that make a lot of headlines, and make decisions on the assumption that today’s reality will persist well into the future. 

This can then affect asset-allocation decisions. Investors extrapolating from today can be overly focused on the short term as a result, and not be correctly positioned for longer-term (and potentially more rewarding) trends. This is particularly relevant during large and unusual moves in markets, such as the aggressive interest rate hikes seen in the US and UK in the last eighteen months. Investors have had to make decisions based on the expected future path of rates, and not just the rate today.   

The key message here is the importance of keeping historical context in mind when investing, because whilst history never repeats itself exactly, it does have the potential to rhyme.

Reducing the impact of behavioural biases

Behavioural biases are systematic deviations from rationality, and we all experience them to varying degrees.

Unfortunately, it’s very difficult to ‘de-bias’ our thinking completely. What we can do instead is to be aware of our own biases, and put things in place to try and limit their impact, such as decision-making rules or frameworks.

One risk to be aware of is ‘confirmation bias’, where individuals seek data and narratives that confirm their own views and beliefs. This can lead to taking more risk, and lower portfolio diversification, than might be sensible given an investor’s risk tolerance, financial circumstances and goals. 

The present excitement around Artificial Intelligence is a case in point, when thinking about the year-to-date rally in equity markets, and all the positive narratives one can find about its future impact. 

Remember, when sentiment is either very bullish or very bearish, it can lead to sudden, dramatic changes which have a big impact on asset valuations, and catch out those investors who have bought into the narratives. 

It is therefore important that investors critically evaluate their views and decisions, ensuring that they are balanced, and challenge their own thinking for potential flaws or biases. A professional adviser can help here by providing an external perspective. 

Practical suggestions

Now we get to an area close to my heart – the subject of behavioural biases. 

For investors, the value of a long-term strategy is well-documented. When markets are in rude health, or conversely experiencing volatility, our biases – essentially, the systemic deviations from rationality – can be exacerbated. And when this happens, investors risk making sub-optimal decisions. As an example, the stress of a short-term market downturn might compel some investors to sell, which might cost them later when markets recover. 

Likewise with F1, a driver might make an error when under pressure from a competitor. To better shield against this cognitive risk, delegating decision-making to experts with tried and tested processes, could help. And in the world of F1, delegation and trust are non-negotiable factors given the complexity and speed of decision-making required.

In reviewing investment decision-making, investors might consider taking some of the following actions during the summer break:

• Think back to all big decisions made, or not made, and objectively review their success or failure
• When identifying times when your judgement may have been flawed, think about what can be put in place to prevent a repeat. Establishing investment rules can be helpful.
• Get the right balance between consuming short-term and long-term information. Having a break from short-term news flow can be helpful in keeping a longer-term perspective.
• Consume more thoughtful longer-term commentary and ideas, as well as historical pieces, to help put current events and short-term actions into a broader historical context.

Depending on an investor’s personal circumstances, they could help to overcome some of the biases that all-too-often make us more short-term in our thinking than is warranted, biases that are reinforced in a social-media age of round-the-clock daily news flow. 

Enacting some of the proposed actions could allow you to return from the holidays better prepared and potentially ready for more successful decision-making in the year ahead. 

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