Anxious investors should ditch emotions and follow simple rules
Have you ever placed an alarm clock on the far side of the room to prevent yourself from hitting the snooze button in the morning? Or moved a bowl of nuts out of arm's reach at a dinner party to stop you from nibbling your appetite away?
As a student of economics, I was taught that it does not make sense to place nuts out of arm's reach; if I did not want to eat them, I would simply choose to stop eating, so why go to the trouble of removing the bowl?
According to author and prominent behavioural economist Richard Thaler, the distinction between what we want and what we choose has no meaning in traditional economic theory.
Equally, a decision to press the snooze button on the alarm clock reveals a preference for a few more minutes' shut-eye. Choosing to wake up is another preference, for which leaving the alarm clock on the far side of the room is unnecessary.
Self-control problems have no place in the rationalist theory of economics. To borrow a phrase from American baseball player Yogi Berra: "In theory, there is no difference between theory and practice; in practice there is."
In real life, the decisions we make are not rooted in rational economic theory and this has wide implications for many facets of our lives, none more so than in matters relating to finance.
Take, for example, the glib assumption of rational decision-making that my own industry (investment) has borrowed from the theorists.
As a result, we have been effectively washing our hands of arguably the most important aspect of what it means to invest successfully - getting investors to stay the course through the inevitable ups and downs along the journey.
In the main, investors do not like volatility and are averse in the extreme to multiple periods of negative returns (which occur with far more frequency than finance theory predicts).
Investors require emotional comfort along the way. Emotion, however, is to be controlled, not pandered to, according to the theorists.
By betting against the powerful force of human fallibility, the traditional approach to investing is setting investors up for expensive failure. A more sensible approach embraces our own emotional fallibility and plans for it.
So here is my tuppence worth on what a sensible approach to investing should encompass. To have any practical hope of achieving long-term financial objectives, investors need to follow a simple (thought possibly not easy) set of rules.
Rule 1. Use a financial adviser or someone not emotionally connected to the investment.
Rule 2. Sign up to a plan that is drafted in a period of calm.
Rule 3. Don't over-monitor your portfolio and make fewer changes than you are tempted to.
Rule 4. Finally, meticulously avoid business television channels or emotionally charged media articles. We only have a certain well of emotional comfort to draw from and it gets depleted, so save it for important stuff.
Don't waste it on the equivalent of guessing a coin flip. Though many in the investment business are loathe to admit it, much of what happens in markets, certainly over the short run, is random and beyond rational explanation. Tune out the noise as much as possible.
The battle against innate biases and self-control issues is a struggle without a finish line, so these rules should be kept under constant review.
Gary Connolly is managing director of iCubed, promoting better investment outcomes through a collaborative approach to investing. He can be contacted at firstname.lastname@example.org or on Twitter @gconno1.
Sunday Indo Business