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Key Decisions to Investment Success
05/09/2013 7:45 am EST
A new book’s strategy for making better decisions can apply to many areas of life, including a more satisfying and profitable investing plan, writes Janet Brown of NoLoad FundX.
Investing is fundamentally about decision making. We have to decide when to invest, what to invest in, and then when to change our investments.
Decisive: How to Make Better Choices in Life and Work, a new book by brothers Dan Heath, a senior fellow at Duke, and Chip Heath, a professor at Stanford, looks at why we make poor decisions and how we can make better ones.
Missed Opportunities. While the book focuses on life and work choices, the lessons are just as relevant for investment choices. We can miss important opportunities if we don’t consider enough options, what the authors of Decisive called “narrow framing” (the one of “the four villains of decision making”).
But we can widen our options “by thinking and, not or.” Rather than assuming we must choose one of two options (to invest in Fund A or Fund B, for example), we should consider what other options are available to us.
Biased Thinking. We also don’t assess our options objectively. Studies find that people rely primarily on information that supports their existing beliefs (this is known as confirmation bias).
Decisive explains that “the tricky thing about confirmation bias is that it can look very scientific.” We think we’re making an informed decision, because we’re gathering information before making a decision, but too often the information we’re gathering isn’t objective.
Reality-checking our assumptions can help counter our biases. The book suggests developing a process that forces us to consider different opinions: “Because we naturally seek self-confirming information, we need discipline to consider the opposite.”
Short-Term Emotions. Some decisions are hard because we’re emotionally conflicted about them. As the book explains, “If our decision was represented on a spreadsheet, none of the numbers would be changing—there’s no new information being added—but it doesn’t feel that way in our heads...In those moments, what we need most is perspective.”
The authors suggest “distancing yourself from short-term emotions, because they’ll often distract you from your long-term aspirations.” For investors, this could mean focusing on long-term investment goals rather than the performance of any single position.
Over-confidence. Fear isn’t the only emotion that affects our decisions; confidence can also be a problem. Most of us think we know more about what the future holds than we actually do.
Given this, the authors of Decisive say we should “prepare to be wrong.” They suggest setting a decision “tripwire” that prompts us to reconsider our decisions, because “sometimes the hardest part of making a good decision is knowing there’s one to be made.”
This is built into the Upgrading process: we recognize that every fund we buy will eventually be ranked a Sell, and so each month we reassess our investments and have a chance to make changes.
We know from our 40-year experience that Upgrading has helped us make better investment decisions, and these insights on decision-making showed us why: the FundX ranks help us take a broad view of the market and keep us alert to many new investment opportunities.
The strategy is a disciplined way for us to regularly “reality check” our assumptions, and it helps us make quantitative decisions, rather than emotional ones. And, although the strategy doesn’t always lead to profitable trades, it does always give us the chance to make a new decision.
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