Thrusting, Decisive and Frequently Wrong
We are both by design and by culture inclined to be anything but humble in our approach to investing. We usually invest on the basis that we're certain that we've picked winners, we sell in the certainty that we can re-invest our capital to make more money elsewhere. We are usually wrong, often extremely wrong.
These tendencies come partially from hard wired biases and partly from emotional responses to the situations we perceive ourselves to be in. But they also arise out of cultural requirements to show ourselves to be decisive and thrusting; we rarely reward those who show caution in the face of uncertainty. But we're private investors, we have limited capital and appetite for risk. A little humility - or even a lot - wouldn't go amiss.
In a recent paper Amitai Etzioni has extolled the virtues of Humble Decision-Making Theory. It's a thoughtful piece and in accordance with much of the evidence curated here over the years. In general we're far too confident in the face of an uncertain future, we end up paralyzed into inaction when everything goes wrong and we then panic when it's too late.
Even worse, when the chaos subsides we almost immediately develop myopia about recent events and rapidly fall back into our old habits. In the last year or so we've seen signs of exuberance in certain areas of markets even though we're less than five years away from the biggest financial crisis in most peoples' memories. We're pulled hither and thither by our emotions and our biases and, for the most part, remain unable to control ourselves.
Work In Progress
Given our lack of control then a rather more cautious approach to investing would seem to be sensible. Even if we can't debias ourselves and we remain subject to the ebb and flow of our emotions then we can at least recognize these limitations, and approach the topic in an appropriately humble frame of mind. As usual, though, we need a metaphor for the moment and, fortunately, Etzioni provides us with one:
"If ... one recognizes that goals tend to be very unrealistic ... and that people ... often do not command the resources needed to achieve their goals, it becomes evident that a better starting point would be to determine the resources at one's command and seek to build on these foundations. That is, people should view life as a fixer-upper rather than as a new construction."
Let's unpick this.
The idea that goals are unrealistic comes back to the general observation that we're very poor planners: most major projects overrun in terms of both cost and timescale. We all want to be millionaires and retired by the time we're thirty but statistically none of us will be (and even if you achieve this you're statistically irrelevant). Investing on the basis that we want to become rich quickly is dangerous and is likely to lead us into taking risks which will almost certainly turn out badly.
In investing terms outwitting the markets in the short-term is very difficult: the securities industry has all the big guns, and we don't have access to the resources necessary to take them on. This doesn't stop most people of course: day trading is the equivalent of a man armed with a slingshot taking on a squadron of drones. Heroic but doomed. And very, very stupid.
The trouble is that we don't know as much as we think we do. We're not very good at processing statistics and we're biased by experience so a particularly vivid or recent memory will be given much more weight than any amount of boring, dry, dull and extremely accurate data. Worse still we simply can't predict the future for better or worse - the CEO of our favorite investment may run off with to South America with the CFO and a stack of cash; or a stupid market crash may make wonderful companies available at knockdown prices. Being humble in the face of this isn't cowardice or a cop-out, it's simply straightforward commonsense.
Culturally we're biased against people who don't make the big calls. The preference of investors for extremely confident advisers and analysts is something I looked at previously, the problem being that we don't adjust for the fact that they're nearly always wrong even after the event. In essence being an extremely confident "expert" conveys the message that you know what you're talking about and carries virtually no downside. On the other hand, if you're cautious and realistic you're far less likely to attract an army of committed followers.
Underlying all of this madness are our hard-wired biases. There's plenty of food for thought in the Big List of Behavioral Biases and the A to Z of Behavioral Bias, without me repeating myself. Although there are measures you can take to limit the impact of these, the real truth is that they're ingrained, the result of millions of years of careful evolutionary development which has been overturned in the space of a century by an unprecedented technological revolution.
We're in the same situation as the bridge builders of Ancient Roman times: we need the bridges but we don't have the math or the engineering skills to guarantee that they'll stand up after we build them. Those ancient bridge builders did something very simple: they over-engineered them, that's why there's an aqueduct still standing in Segovia after 2000 years. Admittedly they also made the engineers stand under them when they removed the supports, which is what I call a proper incentive.
The paper recommends a few simple ideas for the humble investor. Firstly, treat all decisions as experimental rather than formal commitments. This helps avoid theory-induced blindness, where making an initial decision seemingly commits us to a course of action regardless of its consequences. It's a state of mind, rather than a set of rules.
Secondly, be cautious about the extent of your knowledge - securities markets are beset by uncertainty, it is impossible to predict the future and highly risky to gamble on being able to do so. Hedging across different asset classes is a simple way of implementing that caution, although even normally uncorrelated asset classes can sometimes move together. As a corollary to that mistrust any expert who offers very precise predictions, seek out more balanced and nuanced commentators (see: Clueless: Meet the Overprecise Pundits).
Thirdly, don't react to events immediately, no matter how critical it may seem to do so. In the short-term emotional responses distort our decision making processes and enforcing a delay allows us time to calm down and reconsider. Even in the hectic world of securities trading it's unlikely that a 30 minute cooling off break will seriously affect your wealth over a lifetime of investing.
Finally, work as though you're fixing up your home with whatever resources you have to hand, not building a new home with infinite resources. This focuses you on yourself and your situation and provides some respite from our tendency to baseline ourselves against our cohort. We don't have to keep up with the Jones', we'd be better off trying to maximize our own successes, rather than worrying about what everyone else is doing.
Carefully Does It
Of course, the idea that we're subject to the whims of a range of mental ticks that bias our decision making processes and help denude us of our own money isn't a universally accepted idea. To add to this the suggestion that we can't overcome these biases is even less popular. In an age of plastic heroes, can-do attitudes and instant gratification being told that something as seemingly simple as controlling our own urges is impossible isn't going to attract a mass audience of happy nodding people.
But popularity isn't the point: our best defense against both ourselves and a financial service industry dedicated to relieving us of our savings is to be realistic, rather than heroic. In the face of the unknown a little humility is our best protection. Be tentative in your decision making, change your mind if the facts change, diversify widely and don't go around boasting about your successes: be humble, and become wealthy.