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How You Really Make Decisions

A few weeks ago BBC Two repeated a Horizon documentary from earlier in the year called “How You Really Make Decisions” which draws on the work of Professor Daniel Kahneman, an American psychologist. Whilst at first glance this may not seem to be an obvious subject for a wealth management Blog, Kahneman is a leading expert in behavioural economics who won the 2002 Nobel Prize in Economics for his work. He came to the attention of a wider non-academic audience with his New York Times bestselling book – “Thinking Fast and Slow” – which was one of the Economist and the Wall Street Journal’s best books of 2011. This presents human thought processing as being based on two systems. System 1 (Thinking Fast) is intuitive and unconscious whereas System 2 (Thinking Slow) is our more deliberate, rational and conscious method of thinking things through. Most of us like to think that we make our most important decisions using the careful, deductive reasoning of System 2 but in our fast paced ,internet-age lives all too often it is the intuitive System 1 which ends up calling the shots as it can process patterns and information in fractions of a second.

This ability to make instant decisions to overcome and avoid dangers and predators by using System 1 undoubtedly has a great deal to do with the survival and flourishing of the human race. However, it can also lead to us unconsciously making split-second decisions focused on the moment but without going through a process of reviewing all the available evidence. Great for evading sabre-toothed tigers but in the modern world we have to make decisions involving money and investment that will involve a complex evaluation of future needs rather than just the next moment. Often when we need to make decisions using the deliberative System 2 it is influenced by System 1 and we take mental short cuts which are far from the logical approach we think we are using. These intuitive judgements, known as heuristic and cognitive biases, often lead to far from optimal solutions which when it comes to investing can be extremely costly.

As investment advisers and managers a key part of our job at MASECO is to help clients to control these behaviours which can lead to making poor investment decisions such as selling out of portfolios at the bottom of market downturns when driven by fear and panic. The evidence tells us that this “emotional penalty” is possibly as high as 6% a year, on average In the 20 year period to the end of 2008, the US equity market delivered a return of a little over 5% a year, after inflation. The average investor in US funds actually achieved a return of -1% a year1.

For more insights into the quirks of human decision making the programme can be seen here.

 

Cormac Naughten
Head of MASECO Institutional

 

1 Dalbar Quantitative Analysis of Investment Behaviour, 2009 – this study reveals that the average investor in US equity funds lost, on average, 1% of their purchasing power over twenty years to 2008, compared to an average 5.3% return of the market (note that you can own the US market with an index fund for around 0.1%).


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