The trouble with intuition when investing

Welcome to our newsletter. While the race that stops a nation is always a highlight of early November, on the economic front the Labor government’s first Budget, handed down in late October, has been a talking point.

Treasurer Jim Chalmers’ first Budget was delivered against a backdrop of continuing turmoil on the global economic front. The UK reversed its promised tax cuts that spelled the end of Liz Truss’ brief tenure as Prime Minister. She was replaced by the more economically credible Rishi Sunak. In the US, media reports suggested the US Federal Reserve will scale back its aggressive interest rate hikes in December. Both events were welcomed by financial markets, but the same challenges remain. Escalating war in Ukraine, energy supply shortages, rising inflation and interest rate hikes to fight it, still point to a likely recession in the US and elsewhere. Oil prices continue to rise as OPEC restricts supply, with Brent Crude up about 13% this month, but recession fears are moderating the price pressures.

In Australia, economic signals are mixed. Reserve Bank assistant governor, Luci Ellis said in a speech that Australia’s ‘’neutral” cash rate should be at least 2.5%. The rate is already at 2.6% after a 25-basis point rise this month, but further increases are expected. Unemployment rose slightly to 3.5% in September, perhaps indicating labour shortages are easing. The ANZ-Roy Morgan consumer confidence index slipped below its 2022 average of 90.3 on recession fears and the falling Aussie dollar. The dollar fell another 2c to around US63.2c in October. Businesses are more optimistic, with the NAB business conditions index up 3 points to a 15-month high of 25 points in September.

Knowing how your mind works can help you avoid the more obvious traps many investors fall into.

Cognitive bias has become a bit of an investing buzz phrase in recent years.

The theory is that the human brain predictably makes errors of judgment that can lead us to be emotional, short term and come to other incorrect conclusions.

Cognitive bias has been of particular interest to the investing community and long lists of biases – confirmation bias, anchoring, the recency effect and dozens of others – are now the stock-in-trade of beginner investors worldwide.

The Nobel-prize winning economist Daniel Kahneman first researched bias in human thinking, distinguishing two ways in which we think: an automatic, instinctive and almost involuntary style contrasted with effortful, considered and logical thought.

That original research has grown into an industry.

Researchers and psychologists have identified endless ways in which the human brain is prone to bias, errors and poor judgment – and the investing community has latched on.

But underlying it all is that original finding that we spontaneously seek an intuitive solution to our problems rather than taking a logical, methodical approach.

Kahneman wrote that when we are confronted with a problem – such as choosing the right chess move or selecting an investment – our desire for a quick, intuitive answer takes over.

Where we have the relevant expertise, this intuition can often be right. A chess master’s intuition when faced with a complicated game position is likely to be pretty good.

But when questions are complex and rely on incomplete information, like investing, our intuition fails us.

The very fact we find the concept of cognitive bias so appealing is simply another example of our innate desire for simple, intuitive answers.

Unfortunately, the world is complicated, and almost everything that happens in investment markets emerges from the combination of a web of unrelated, intricate and multi-faceted events.

Our bias towards simplicity is reinforced by the nightly news and the morning newspapers that persist in providing simple explanations for complex events. Each day, market movements are distilled into ‘this-caused-that’ explanations that obscure the true drivers of change.

It is our intuition that is reacting when we find ourselves excited that markets rose 100 points – and a little nervous when markets ‘wipe off’ billions. We experience these emotional reactions even though the effect on our overall wealth from either event is likely to be tiny.

Our understanding of history is similarly simple, reducing wars, recessions and pandemics into simple cause and effect stories that are easy to remember and teach.

These stories help us understand the past. But they do not help us predict the future.

This explains why investment opportunities that seemed certain at the time we made them so often go awry.

It is not bad luck or circumstances changing against us – it’s the fundamentally simplistic cause and effect model in our minds that doesn’t allow us to understand all the possible outcomes.

So how can we best use the science of cognitive bias to become better at investing?

It is certainly worth learning about the wide and growing range of cognitive biases scientists are identifying that can stand in your way of being more successful.

Knowing how your mind works can help you avoid the more obvious traps many investors fall into.

We can use the basic principles of successful investing to avoid becoming victim to our own cognitive biases. Stick to a plan and don’t react to market noise or your emotions. Stay diversified to reduce the risk of permanent loss. And ensure you do not spend too much money on unnecessary fees.

But it is also a trap to rely too heavily on the science of cognitive bias, thinking that it can provide you with the keys to investing success.

The serious research being done by psychologists has been co-opted to offer you yet another tempting short cut – and in successful investing, there is no such thing.

Source: Vanguard

Reproduced with permission of Vanguard Investments Australia Ltd

Vanguard Investments Australia Ltd (ABN 72 072 881 086 / AFS Licence 227263) is the product issuer. We have not taken yours and your clients’ circumstances into account when preparing this material so it may not be applicable to the particular situation you are considering. You should consider your circumstances and our Product Disclosure Statement (PDS) or Prospectus before making any investment decision. You can access our PDS or Prospectus online or by calling us. This material was prepared in good faith and we accept no liability for any errors or omissions. Past performance is not an indication of future performance.

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