How small changes lead to big investment outcomes
By Allan Leung, CFA 11 December 2018 4 min read
Awareness is the first step in mitigating poor investment (or life) behavior. For example, when attempting to diet a decision can be made to keep our favourite late-night snack out of the house. This is a smart yet simple strategy to help mitigate a biased choice. Removing the option for poor judgement allows us to focus on our intended long term plan.
Cool state versus hot state
In his book Predictably Irrational, Dan Ariely, Professor of Psychology and Behavioral Economics at Duke University, blames our lack of self control on our two states of judgement: hot state and cool state. In our cool state, we are able to make rational long-term decisions. In our hot state, we tend to give in to instant gratification and put off decisions made in the cool state.
In investment terms, rational investment decisions anchored by our long-term objectives are made in a cool state. In a hot state, we invest in the “hot stock”, giving in to an irrational urge. We are often inadvertently pushed to a hot state due to outside influences such as media reports, news feeds and digital information which may or may not be accurate.
Half of what is reported in media suggests the economy is in trouble while the other half talks about economic recovery and new highs that are being achieved. Given all the noise, it can be challenging to remain in a cool state. It is in this state where we are able to focus on the longer term and reflect back on our financial plan to ensure we are on track.
Small changes lead to big outcomes
Having a plan in place can help revert our thinking from “instant gratification” to “long-term success”. When investors relate to their plan, it encourages questions such as how will this decision affect my retirement? A plan can help curate long-term thinking which typically translates into better investment decisions.
Consider this fitness analogy: you have never run a race before and decide one morning to run a full marathon. How do you think your body would respond? How long would it take to recover? That said, if you intentionally created a training plan, running that marathon would be far less daunting - and your body would take far less time to recover!
Building your body up from running a few kilometers a day to running the full 42 kilometers required for a full marathon takes conditioning over time. The concept here is that small changes lead to the creation of lasting habits that become automatic, and trigger positive actions in our daily lives.
The importance of goal setting
To create an investment plan that facilitates the achievement of your financial and life objectives, focus on setting specific goals. These can be goals that you want to achieve as an individual or family. Don’t base goals on what your friends or neighbors are doing. Once you’ve defined those goals as part of a financial plan, it’s time to complete a risk tolerance assessment. This should be an honest assessment of how much volatility you can manage before feeling uncomfortable.
If seeing a loss creates feelings of anxiety, your portfolio should be positioned more defensively to help limit that volatility. This portfolio positioning is referred to as asset allocation and represents the split between equities and fixed income within a portfolio. More defensive positioning means fewer equities and lower long-term return potential. More aggressive positioning means higher equities and (usually) a higher long-term return potential.
The goal of asset allocation is to balance desired long-term returns with your individual risk tolerance. This will help to remain invested over the long term and not give in to short-term biased thinking. Disciplined asset allocation helps take the emotion out of investing and is the single most important factor in the investment process.
Steering away from the noise
Professional financial advice can help to navigate the markets. Steering investors away from short-term thinking and reminding them of their long-term goals. Your financial advisor should serve as a translator and help distinguish between “media noise” and actual signals in the market that you should pay attention to. Successful investing is a blend of constructing the right asset mix for a portfolio and managing our emotional - sometimes irrational - reaction to short-term market changes.
Sticking to your plan
While these four behaviours may seem simple, the application of them can be quite difficult at times. You work hard to earn and save, and markets are unpredictable so its normal to feel some anxiety. One of the primary roles of your financial advisor is to help you recognize emotional decision making that can lead to poor outcomes, by helping you to stick to your plan and following tried and true principles.