By Chris Shuba, Helios Quantitative Research
A machine…really? Yes. Machines don’t get sick or tired. Machines don’t have emotional bad days. More importantly, machines don’t care what you or your clients’ think about them. Machines just do their jobs.
Obviously, Financial Advisors are not machines, and that’s a good thing. But smart Advisors use quantitative processes and systems to help them avoid the following pitfalls and focus on compound return rates:
- Making uninformed decisions
- Taking risky short-cuts
- Expecting unrealistic results
- Focusing on the short-term
With that in mind, below are four sure-fire ways to help you think more like a machine, without becoming a robot.
#1 Don’t act impulsively
Daniel Kahneman famously uses the old bat and ball analogy to illustrate how the human mind jumps to an incorrect solution when the answer ‘appears’ to be obvious, simple and logical. Kahneman’s analogy goes like this:
- A bat and ball cost $1.10.
- The bat costs $1 more than the ball.
- How much does the ball cost?
Most people jump to the ‘intuitive’ answer: $0.10, but the correct answer is $0.05. If you missed this one, don’t feel bad, more than 50% of the students at Harvard, MIT, and Princeton got it wrong too.
Once a decision is made, even an incorrect decision, we move forward from that decision-point and rarely look back. As you can imagine, basing future decisions on a false decision-point can lead to disappointing results.
To minimize decision-making errors, it helps to follow a process, like machines do. We start by recognizing that investors and their Advisors face a staggering amount of base-rate neglect. Simply put, when making a choice, we must know our odds. If I’m considering investing in the S&P 500 or an Emerging Markets fund, it helps to know the odds of success. If the odds favor me, then it is reasonable to select the risk-adjusted return that gets closest to my target. Which means I pick the investment with the best opportunity for a desirable outcome – which is not always the one with the highest potential return.
ALL human beings battle their intuitive-mind because it loves to make quick and often hasty decisions. This is particularly true when the investment does not seem viable at the moment we look at it.
As seasoned Advisors, we know it is easy to make an impulse-decision and recommend an investment that has ‘always’ done well. We also know that supporting a long-established investment may not be the right choice for a given client. From a machine’s perspective, it understands that investments continually move toward or away from their averages, which means an investment that produced well over the past few quarters might be the worst choice for a client going forward.
Machine-thinking means that an Advisor will avoid making a time-honored decision just because it is the obvious, simple and logical choice.
#2 Don’t confuse the common with the uncommon
One major cause of our base-rate neglect comes from the availability heuristic, which is a fancy term that means human beings take mental shortcuts. We often make snap-decisions based on learned or virtual examples that pop into our heads. The availability heuristic is a brain function that causes us to believe a situation is far more common than it really is, or vice-versa.
As an example, movies we saw as children make us think we are in danger every time we walk down a dark alley. The odds of being attacked might be slight, but having seen movies to the contrary, we believe that alley-attacks are a common occurrence in the real world.
To think like a machine, we must be extremely clear about the actual odds of success or failure with every decision, regardless of what the odds feel like emotionally. This is challenging because our availability heuristic tendencies are so strong.
#3 Understand you are going to lose money
Loss aversion is a principle well known to Advisors. It states – people fear losses more than they value gains. Given the short-term focus of many investors, the pressure to ‘win’ every time is painfully real. Machines understand that it is impossible to win every time, so they don’t try. In fact, just trying to win every time creates enormous opportunity for significant losses – which may take investors years to recover.
Related: The Death of Basis Points?