In memory of Dr. Andreas Höfert

Why it's not easy to make disciplined investments

| Tags: Andreas Höfert

If you travel a lot like I do, and therefore spend a lot of time in airports, you will certainly have noticed the many finance books in the bookstores there. In these books, one advisor after another tries to tell you how to be a successful investor, how you can increase your assets two-, three- or tenfold in no time at all, how to always win on the stock market without fail, and how you can profit from the next rally or the next crash.

I always ask myself who reads these books, but even more I wonder who writes them. Do successful investors have nothing better to do than write books for airport kiosks? Or perhaps they aren’t so successful, so they have to earn their money through writing?

Among the – few – economists who are wealthy, there are significantly more who have made their fortune from writing books than from successful investing. I can only think of two well-known economists who were also skilled at the stock market: David Ricardo (1772–1823) and John Maynard Keynes (1883–1946). Both also wrote books – not about their success as investors, but rather treatises on macroeconomic and fiscal policy.

There are three traits that, in my opinion, characterize successful investors. First, they must follow clear investment strategies that are based on their individual needs and conditions, the objectives that they would like to achieve and the risk that they are truly capable of absorbing. Second, they need a systematic analysis of the financial markets in order to identify both investment opportunities and risks.

And third – and this, in my view, is the crucial point – they must have the discipline to implement the chosen investment strategy consistently. Because in the end only disciplined implementation of a specified investment strategy guarantees investment success over the long term.

However, discipline is usually in short supply, and therefore many investors only have below-average success. Why is this? Economic theory presupposes that humans are rational and act accordingly. According to the “homo oeconomicus” model, we are all econometrically savvy machines who go around making decisions according to a cost-benefit analysis, based on an efficient use of the available information and with a complete understanding of statistics and an optimal weighing of the likelihood of the risks and rewards.

Of course, most of us do not recognize ourselves in this caricature. Many of our decisions are made according to emotions, feelings and opinions, not on an absolutely rational basis. We think that when push comes to shove, we can make decisions without emotion. Unfortunately, this is not true, as psychologists demonstrated in the 1960s when they used simple experiments to show that people have a tendency to systematically make the wrong decisions and that they are subject to cognitive bias.

According to these findings, particularly those of the research by Daniel Kahneman and Amos Tversky (Kahneman won the Nobel Prize in Economics in 2002; Tversky had unfortunately already passed away by then, otherwise he would have shared the prize with Kahneman), there are essentially two mechanisms that are responsible for our decisions. The first mechanism, which Daniel Kahneman defined in his book (Thinking, Fast and Slow, New York: Farrar, Strauss and Giroux, 2011) as system 1, is quick, intuitive thinking, where our decisions are made before our consciousness is even aware that we have made them. The second mechanism of thinking (system 2) is much slower, requiring a lot of energy, and is therefore usually only consciously used if there are complex problems. Why do we even have such a two-tiered decision-making system?

Imagine wandering the savanna 80,000 years ago. Suddenly, you hear rustling in the tall grass. With system 2, the rational system, you would deliberate about whether it was a saber-toothed tiger or not. In doing so, however, you would lose the crucial head start that you would need in order to survive if it really was a saber-toothed tiger sizing you up as potential prey. In this situation, system 1, in which you immediately start running without thinking at all, is superior to system 2. The worst that could happen to you in this case is that there is no saber-toothed tiger and you therefore ran for nothing.

What worked as an efficient survival mechanism on the savanna 80,000 years ago can very quickly be revealed as a rash action in our modern world, particularly when complex, well-reasoned decisions are required. This includes investing. How quickly you follow system 1 when making investment decisions can be shown using an example.

Let’s compare the following propositions and consider which is more likely.

  • The euro crisis could reignite.
  • Greece remains mired in financial distress and must therefore ask the EU for a new bailout program. Because of the pressure that political parties in Germany feel as a result of the “Alternative for Germany” party, the EU’s largest creditor could react parsimoniously, reigniting the euro crisis as a result.

Most people would consider the second scenario to be more likely because it is accompanied by plausible arguments and details. The more detailed a scenario is, the more we can imagine it, and the more likely we perceive it to be. However, this contradicts a basic rule of probability theory: An event becomes less probable the more details we add. The euro crisis may reignite for some reason – Portugal, Spain, France, or Cyprus run into trouble. Greece is only one possible scenario, and therefore the second scenario is less likely than the first.

The “availability heuristic” also works in a similar context. The more readily an event comes to mind, the more likely we think it must be. We classify events that occur rarely – or more accurately, that we hear about less – as less likely. Is someone in the US more likely to die from a shark attack or from being hit by debris falling from a plane? Because of the media attention focused on shark attacks, you might think this cause of death is more likely. However, you are 30 times more likely to die from debris falling from a plane (1 in 10 million) than from a shark attack (1 in 300 million).

The availability heuristic also explains why most investors, analysts and economists found it difficult to recognize the dot-com bubble in 2000 and the US housing market bubble in 2007. Then-Fed Chairman Ben Bernanke predicted another rise in US housing prices as late as 2006 because there had never been a price correction for the entire US housing market. Now, following the experiences of 2000 and 2007–08, the likelihood of an investment bubble seems to us to be significantly higher. As a result, hardly a day goes by without an investment specialist predicting the next mother of all financial market bubbles. It remains unclear many of these are based on accurate analyses and how many on the availability heuristic.