Are you and your clients committed investors for the long term, with a carefully devised plan to meet goals?
Investors can find it remarkably difficult to stay true to their plans over time. Whether you focus on minimizing fees, maximizing momentum, or uncovering fundamental valuations, there are many pressures to stray—from the urge to chase returns, to getting caught up in fads, to running scared when the markets turn rough. But why don’t we resist those temptations? Why don’t we stick to our guns?
One of the most troubling reasons is simply self-deception: Investors just don’t realise that they are breaking their own rules.
Behavioural scientists have conducted fascinating studies into why we self-deceive—and how we can structure our environments to do better. While the field is quite new, there are some promising approaches investors can take.
The devil on my shoulder
Self-deception starts with something so simple, we often forget it: We want impossible things. In particular, we want to both be good upstanding people who follow (our own) rules and get the benefits of cheating on those rules, too.
When it comes to investing, we want to stick to our plan and we want to get the benefit of ignoring the plan—whether that benefit is the allure of higher returns or relieving our panic by ditching a “declining” asset.
So what do we do?
We try to have them both, of course. When faced with conflicting incentives, people try to follow both sets of incentives at the same time. They balance their self-image as an honest person with the temptation to cheat—by doing a bit of both.
Let’s say you have a valuation-driven investor, whose long-term portfolio isn’t performing well in the short term. The investor might fudge things by picking up a few hot stocks that will make things look healthier, while keeping the rest of the portfolio constant.
Fudging things
There’s a limit to how far we can cheat and still maintain our image of an honest, virtuous person. To put a number on that limit, Nina Mazar, Dan Ariely, and others1 ran experiments in which people did a moderately complex math task.
In one version of the study, people completed the task, submitted their answers, and were paid based on how many they got right. In another version, participants finished the task and were given the list of correct answers. They were then asked to self-report how many they had solved correctly, so they could get paid, You’ve probably guessed it—when people had the opportunity to cheat, they did so.
The amount of cheating depends on the exact scenario, but in this straightforward scenario, people cheated by a whopping 50%. They claimed to have solved 50% more math problems than they actually had. The researchers called that margin of cheating “the fudge factor.” The results are replicated across a variety of areas, and without other inducements, the researchers found that the fudge factor ranges from 10% to 50%.2
The most troubling part, however, was that the participants didn’t know they were cheating. It appeared that they did it non-consciously, or somehow rationalized and believed in their newfound mathematical abilities. When asked to predict how many they would get right in the future—in a different situation when they could not cheat—people responded as if their cheating- fueled abilities would remain. In other words, they successfully deceived themselves.
In addition, it isn’t just a few bad apples or deluded people; most people in these studies bend the rules and deceive themselves about it.
In the investment world, what does this represent? Straying from one’s principles likely isn’t a problem of a few weak-willed investors. The problem is fundamental to us as human beings. We want to have our cake and eat it, too. We want to have a clear, thoughtful investment strategy and invest in areas we shouldn’t. We want to fudge things.
Some great ways to make things worse
One the main factors that facilitates people bending the rules is what’s known as psychological distance. The game of golf gives us a great example of that. Ariely and others did a study with golfers that shows how powerful a little psychological distance—aka, plausible deniability— is.3 They asked whether the average golfer would be likely to move the ball to a better spot, without counting the stroke.
Only a small portion, about 10%, said yes. They also asked about nudging the ball with one’s foot—to the same effect. More, 14%, said yes. And finally, they asked about just tapping the ball with the club but not actually making a stroke—many more, 23%, said that’s OK. It’s the exact same outcome, and all of them are cheating. But the mere distance between the person and action make it more OK to cheat.
In addition to psychological distance, many other factors increase people’s likelihood and amount of bending of the rules:4
- Ambiguity—the more unclear or complex rules are, the greater the self-deception.
- Where we see others bending the rules, and we don’t see the person being punished.
- When we’re in an environment where it’s considered normal.
- When we work in teams.
- When we bend the rules in the name of a company or someone else you’re helping.
- When we’re simply tired from working long hours or skipping meals.
And what scenario does this describe better than investing? Ambiguity and complexity—sure! Investing to help others, like our family or heirs—yes! Seeing lots of examples of other people doing foolish things that seem to be rewarded (at least in the short term)—check!
What does this mean for our hypothetical valuation-driven investor? Psychological distance happens when you’re calculating the fundamental value of a company and the company looks promising but not quite there. Maybe changing a parameter in your analysis from 3.2 to 3.3 makes it a good deal. Not a big thing—just a parameter. That’s psychological distance in a pure and pernicious form.
Similarly, what is valuation- driven investing but a set of complex, nuanced rules? The concept is simple, but the execution is tricky—and ambiguous. Or, looking more broadly, what investor hasn’t worked long hours or skipped a meal? As investors, we have a great setup for bending our own rules.
Staying the course
Thankfully, all is not lost. There’s quite a bit we can do to remove the fudge factor and make it difficult to rationalize our own missteps. You can think about it as a five-step, iterative process:
- Set the ideal—like a valuation-driven portfolio— to support your specific goals.
- Structure the environment to make it easy to act accordingly.
- Measure outcome rigorously to remove ambiguity.
- Set up feedback so that metric is seen and paid attention to.
- Ensure that you can, and have the incentive to, correct course when things have gone wrong.
Careful measurement is probably the easiest of these. We know intuitively that if we want to follow an investment strategy—like minimizing fees—we have to actually assess how much we’re paying in fees. Thankfully, our field (and Morningstar Direct) is awash with metrics—about fees, about P/E ratios, about sustainable investing factors, etc. There are metrics for whatever we might care about; they aren’t perfect, but they are a great foundation.
Feedback is a harder one. Metrics are only useful when people look at them. In order to smooth the path for feedback, we should automate the process of receiving updates (with a standard report) on the information we care about.
In terms of structuring our environment, we can take many ingenious paths. If we’re tempted to chase returns, we can block our access to sites (and TV shows) that scream at us with tales of hot stocks.
Advisers can ask clients a series of “slow me down” questions before they make changes. To align our incentives to fix problems, we can use good old-fashioned peer pressure— by pre-emptively telling our colleagues, family, and clients that we follow a particular strategy and that we’d be fools to give into temptation and change that strategy. That raises the stakes and makes it easier to get back on track.
This post initially appeared on Morningstar Advisor.com
