A lady – let’s call her Simone – came to see me recently with a problem.
“A year and a half ago,” she told me, “a family friend convinced us to sell our investments because he said a big crash was certain to happen. Well, there was no crash… We are wondering how to get back into the markets. »
I receive a few similar testimonies every year. For all kinds of reasons, good and bad, people panic. They sell their investments and find the proverbial peace of mind. Then the markets resume their rise, and they cannot decide to buy back investments which have since increased in value.
One of the researchers who devoted his life to studying these kinds of decisions was Daniel Kahneman, a professor of psychology at Princeton University and Nobel Prize winner in economics, who died last month at the age of 90.
With his colleague Amos Tversky, Daniel Kahneman founded the field of behavioral finance. Their discoveries regularly inspire the content of this column for the simple reason that they were pioneers in the way we approach investor behavior with money.
Before Kahneman and Tversky, it was believed that investors were rational, reasonable beings who made every decision based on their interests and expected returns.
Kahneman and Tversky took a big swing at this black-and-white image frozen in the 1950s. The minds of investors, they said, are more like a surreal Salvador Dalí canvas, covered in a thin varnish of self-justification impossible for its owner to see.
Investors make emotional and inconsistent decisions. They create immutable laws in their heads from biased and fragmentary information. Worse: in most cases, they do not learn from their mistakes, which they attribute to external factors to preserve the illusion of rationality of control over their decisions.
“Our comforting conviction that the world has meaning rests on a solid foundation: our almost unlimited capacity to ignore our own ignorance,” writes Daniel Kahneman in his best-selling book System 1 / System 2 – The two speeds of thought. We are not designed to know how little we know. »
Kahneman and Tversky (who died in 1996) noted that the human mind is excellent at identifying errors in judgment that others make, but terrible at looking in the mirror and realizing that those same errors are present at home. This leads to overconfidence.
“An investment that is said to have an 80% chance of success seems much more attractive than an investment that has a 20% chance of failure,” Kahneman said. The mind cannot easily recognize that they are the same thing. »
Researchers are also behind the realization that humans are much more affected by a loss than they are happy by a gain. It is to avoid making a loss that many investors will, for example, sell in anticipation of a fall, or keep investments in their portfolio that have given poor results for years rather than getting rid of them.
We also tend to minimize our bad moves, and give more space to our good moves, which can push us to overestimate our results as an investor.
Kahneman suggests we don’t view our gains and losses in isolation, but consider what they represent as a percentage of our assets. “The value of my Visa shares has doubled” is nicer to say than “the total value of my portfolio is up 3%,” although they may be the same thing.
What to do in the face of such a verdict?
Kahneman and Tversky were rather pessimistic about humans’ chances of overcoming their own biases and blind spots. Rather, their approach was to:
1) Recognize that fallibility is an immutable component of decision-making.
2) Establish mechanisms and rules that allow us to overcome the limitations of the human mind.
For example, Daniel Kahneman believed that investors should not stock pick or try to predict stock market movements, but rather buy the market regularly through a diversified index fund.
“All behavioral economists are against active investing because we think the market is unpredictable, or very, very difficult to predict,” he said in a 2018 CFA Institute interview.
Read the interview (in English)
Which brings us back to Simone, the lady who sold her investments a year and a half ago.
What would Daniel Kahneman recommend?
He would probably tell her that one way to minimize bad behavior is to introduce an objective external person. This could mean entrusting your investments to a financial advisor, portfolio manager or financial planner. This person may short-circuit extreme future decisions, such as selling in an attempt to time themselves with the market, a behavior that increases our chances of having a bad long-term investment experience.
As for the decision to return to the markets, he would perhaps tell him that even if studies show us that the statistically optimal decision is to immediately repurchase, the human brain could react badly if a decline were to occur. And so that divide the amount and invest a slice every 1er of the month could be a good compromise.
Above all, he would tell him to remove his emotions from the act of investing.
And he would tell her with a smile, knowing that it’s impossible.