Many of you may know that golfers often fall victim to mental “distractions” that severely inhibit the quality of their game. However, those “distractions” also translate to the marketplace–where innate biases hinder our judgment when choosing investments.
Every amateur golfer knows the frustration of trying to fix their game in the midst of a round. We have all “analyzed” the myriad elements of our swing while on the course, and, after hitting one good shot, assumed that we had found the solution to our swing problems. But, even after incorporating that adjustment into our next swing, we still mishit our next shot. What gives?
Most amateur golfers don’t react correctly to bad shots during a round–many assume that they need to make swing adjustments after hitting a poor shot. Although self-diagnosis occasionally works, such mid-course corrections typically deliver inconsistent results. Better golfers, those who routinely shoot in the 70s, don’t find themselves tweaking their game during a round. But, adjustments can result in sustained improvement if they are integrated into a consistent swing routine.
Mid-round fixes are comparable to ad-hoc decisions and they are rarely helpful in golf or investing.
What are ad-hoc decisions?
Ad-hoc decisions are reactionary courses of action that arbitrarily vary according to situation. For example: while reading the WSJ’s business section, one morning, I see a headline, “Gillette’s New Weapon in Razor Arms Race.” After reading about Gillette’s new state-of-the-art razor, I call my stockbroker and tell him/her to buy me 1,000 shares of Procter & Gamble (owner of Gillette).
Now, one might find my course of action in the previous example harmless, even shrewd. However, upon closer reflection, my behavior was undoubtedly flawed. Wes provides useful insight into my imperfect reasoning:
“Behavioral finance researchers have found that investors behave in a predictably irrational manner. The reason? Humans are flawed decision makers. Sure, at our best we’re capable of amazing things like logic, humor, deduction, abstract reasoning, and imagination. But our brains were adapted for life in the wild, where split-second decision-making meant the difference between life and death. We developed mental shortcuts–called heuristics–that enable us to identify a snake and jump away before we are conscious of the snake’s presence. When we realize moments later that the ‘snake’ was in fact a stick, we are a victim of the heuristic that avoids snakelike objects. These heuristics–useful as they are for our survival–give us a number of cognitive biases that impede us in our efforts to make rational or optimal decisions.”
My decision to purchase Procter & Gamble equity after reading a flattering piece in the WSJ is an example of humans’ anchoring and adjustment biases, which refer to our propensity to rely too heavily on one piece of information when making decisions. While Procter & Gamble may very well be a quality stock, impulsively buying its shares is irrational (much like impulsively implementing a new swing “fix” mid-round is “hit or miss”). If its market value per share is trading at a premium to its book value per share, then I am effectively buying a “glamour” or “growth” stock as opposed to a “value” stock, which is financially thoughtless for obvious reasons.
Think of it like this: stock X is a quality business. But, due to a recent wave of good press, the market currently values it at more than its fundamental worth. Regardless of how effective a business it is, stock X will ultimately revert to its intrinsic value, which is less than it is valued at at the moment. So if I bought stock X when it was overvalued, I would lose money on my investment.
A Case for Systematic Decision-Making
In golf, as in investing, employing a systematic pre-shot routine is fundamental to achieving consistently good results. A practiced, undeviating routines minimize the variability of each golf shot, because it enables golfers to repeatedly and reliably align themselves to their target. That is why so many pros have a pre-shot checklist–to get aligned with their targets. Proper alignment to the target is the surest way to produce cleaner shots. So if you suffer from chronic mishits, it might be time to consider a systematic approach to the game of golf so you don’t end up being the guy with the perennial excuse, “I don’t get it! I never chunk my 5 wood!”
The same methodical approach applies to investing. While a systematic routine for golf produces more consistent contact by reducing the number of mishits, a systematic approach to investment produces more consistent investments by reducing the extent to which errors in reasoning (cognitive biases) influence our decisions.
One way self-aware investors can control their innate weaknesses is by automating how they invest in securities. In other words, a portfolio manager can create an algorithm (a step-by-step procedure) by which to choose stocks, and then let a computer do the “picking” for them. Choosing an algorithm for investment is very similar to choosing a pre-shot routine for golf: research and analyze the defining characteristics of a good investment (a good swing), isolate those characteristics, and then incorporate the information into an evidence-based procedure (pre-shot routine). While some may balk at this notion, computers are not susceptible to behavioral biases for the obvious reason that they’re not human.
Disclaimer: I am not a golf pro, swing coach, or sports analyst. The use of any information from this blog post does not guarantee the reader lower scores.
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