Making better decisions

Words of caution from psychologists, but the wisest of all are from a fellow blogger and value investor…

“Even the wisest people won’t make good choices when they’re not rested and their glucose is low,” says social psychologist Roy F Baumeister.

A new book describes willpower as a muscle that gets fatigued the more you exercise it. By making subjects hold their hands under cold water or suppress their laughter as they watch comedy routines, researchers are testing willpower and finding we are more likely to shirk a decision or make a rash one when we have already made lots of taxing decisions. The science sounds like fun, but some of the revelations are startling:

• Parole boards grant parole 70% of the time early in the morning but only 10% of the time late in the evening.
• The poor are continually struggling with trade-offs, which impair their decision-making and keep them trapped in poverty.
• To diet, we need to exercise will power, but for willpower we need glucose. See the Catch-22?

The main lesson seems to be avoid making decisions when you are tired or hungry. “The best decision makers,” Baumeister says, “are the ones who know when not to trust themselves.”

Dan Ariely says financial advisers ask two useless questions. The first they answer themselves, the the second can’t be answered

The first question is how much of your final salary will you need in retirement. People routinely answer 75%, which is the rule of thumb they’ve heard from financial advisers. “You can see the circularity and inanity”, says Ariely. If you ask people what they want to do in retirement, they actually need 135%. The second question  is how much risk you are prepared to take on a scale of, say 1 to 10. Experiments show that people always plump for slightly below or above the middle, even when the scales are themselves skewed towards high or low risk.

Ariely still sees a role for planners, though, as coaches helping us rationalise the costs and benefits of spending now, versus later.

Since the future is unpredictable, maybe master plans are inappropriate for investors. Geoff Gannon prefers principles over planning, and its opposite, trial and error.

The trouble with trial and error is it helps you adapt to your environment now. For investors, the errors, the feedback loop which guides you in the process of trial and error, are only apparent a long time in the future. Reckless investors responding to rising prices can profit for years before they get their comeuppance, and well-intentioned investors responding to falling prices capitulate during market-panics before they get their reward.

Plans rarely survive the future and trial and error breeds short-termism. Better to follow principles, like investing in good companies at cheap prices, and periodically check you’re still following them.