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[1].
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[2], 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?
Machines expect to lose occasionally and expect to manage their losses as part of the standard process of realizing positive long-run compound rates. Giving yourself permission to fail (for the right reasons) will help you stay process-oriented, like a machine.
#4 Understand what builds wealth
It takes money to make money. Yes, the ancient adage is true – but not for the reasons many people think. For years the financial services industry conditioned investors and their Advisors to focus on the simple short-term rate of return instead of the long-term compound rate.
Why would they do that? It’s simple…
The short-term return, often, looks good. Plus, the Advisor is afraid that if the short-term performance does not meet the client’s expectations, they may leave.
Also, if an Advisor performs poorly during a short stretch of time (a quarter), by using tight windows to evaluate an investment, it is easier for the Advisor to refocus her client’s attention on the ‘great’ quarter that is coming up, and “forget” about the weak previous quarter. As an example, an Advisor may choose to talk about year-to-date numbers because the end of last year was ugly.
How many retail investors claim that they focus on the long-term, but really make decisions based on the short-term? These examples and many others lead to increased short-term risk and remove the focus from the long-term compound rate. Consider this example:
You have two portfolios that start with $10,000. After five years they look like this:
- Portfolio A: $12,000
- Portfolio B: $18,000
Which client would be more satisfied if the following year looked like this? Pick one:
- Portfolio A: 7% ($840 gain)
- Portfolio B: 5% ($900 gain)
Unfortunately, most clients would think Portfolio A that made 7% was the “better” portfolio for the year, even though Portfolio B made more money. Wealth is determined by dollars, not by percentages – and as you can see, it takes money to make money. What matters most is the value of the portfolio, not the rate of return applied to it during the short-term.
The Best Investors Don’t Just Use Machines, They Learn from Them
People are amazing, beautiful and awesome creatures! But, most people are programmed to be lousy investors. Of course, this condition is why Financial Advisors exist.
The human mind, despite its immense power and potential, is programmed to make snap decisions. As a result, people make many more incorrect decisions than correct ones, and this programming applies exponentially to financial investing.
Bottomline, cracking the code to long-term wealth creation is improved when we learn to think like a machine.
This article was written by Chris Shuba, founder of Helios Quantitative Research, a participant in the ETF Strategist Channel.
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[1] Correct answer looks like this: $1.05 + $.05 = $1.10; $1.05 – $.05 = $1.00. Incorrect answer looks like this: $1.00 + $.10 = $1.10; $1.00 – $.10 = $.90.