We all like to think of ourselves as rational creatures who make the best possible decisions all the time, based on all of the available data. Unfortunately, for most of us, this is rarely the case. In fact, the vast majority of human beings have whole sets of biases, prejudices and mental short cuts we’re not even consciously aware of, but which we use on a daily basis to make our lives simpler and more manageable.
According to Nobel Prize-winning psychologist Daniel Kahneman, this phenomenon occurs because our brains operate on two completely different systems: System One and System Two.
System Two thinking is what we use when we really need to analyze a lot of data, solve a difficult math problem, or make decisions after thoroughly examining all the facts. System Two takes a lot of time and energy, so we tend to avoid it whenever possible.
When we use our System One brains, on the other hand, we rely on our experience or a “gut feeling” to jump to quick, instinctive decisions that we may not have made if we’d taken the time to really think it through. System One thinking tends to rely on generalizations, whether it be about people (“conservatives are all the same”) or investments (“stocks are just too risky”). This kind of analysis doesn’t take much effort, so our brains burn up very little energy. That’s why we all like System One.
System One thinking is fine when we’re making a decision about something that isn’t terribly important, like which route to take on our commute home or what flavour of ice cream to have for dessert. But when it comes to our investments, one of the System One heuristics that’s worth paying particular attention to is Intervention Bias.
Intervention Bias is our tendency as humans to introduce changes that aren’t necessary, in order to feel like we’re in control of a situation that’s actually completely out of our hands. The problem is, those actions can often cause a great deal of harm to the very thing we’re trying to protect.
It’s like a gardener who starts worrying that his carrots might not be growing properly, so he decides to dig them all up to check. The short-term result is that he feels he’s at least doing something to take control of his situation. But the long-term consequence is that there might not be any carrots left when it comes time to harvest.
Now, there’s no shortage of times when it makes sense to introduce changes into our investment strategies. If you look at your portfolio and see that you’ve invested pretty much all your savings in one sector or geographic area, or you realize that half of your retirement nest egg is tied up in a single stock, then that’s a really good time to introduce change by diversifying into the rest of the world or other sectors of the market.
Good investment changes like diversifying your asset mix are System Two changes. They come about because you’ve looked at the data, concluded that your existing portfolio is objectively unreliable, and introduced changes that will increase the likelihood that your financial plan will come to fruition.
Where we get into trouble is when we start using System One thinking to make changes in our investments. For example, you look at your investment statement, see that your Canadian stocks are down, and decide to sell them to buy more of something that’s working better.
So what’s wrong with doing less of what’s not working, and more of what is working? Well, absolutely nothing – so long as you used your System Two brain to define what “working” really means.
We all know that stocks go up and down. So if you have a group of stocks that, over time, are going to give you a good long-term return, you probably don’t want to sell them when they’re down to buy something else that’s already going up.
In fact, if you believe in the principle that buying low and selling high is a good idea, you should probably do just the opposite – sell some of whatever is temporarily “working” (i.e. selling high) to buy more of whatever is currently “not working” (buying low). That’s the difference between System One and System Two thinking. And it can have a tremendous impact on the long-term performance of your investments.
To add to the challenge, we also all generally want to be part of a crowd. If everyone else is selling, we want to sell, too, so we won’t be left out. Similarly, most of us wait to buy until everyone else is lining up to do the same. When repeated again and again over the course of a lifetime, that crowd-thinking urge combined with our Intervention Bias to want to “do something” can result in significantly worse results than if we’d used our System Two rational thinking, and simply left well enough alone.
As Warren Buffett said in his 2014 letter to investors: “Investors, of course, can, by their own behavior, make stock ownership highly risky. And many do. Active trading, attempts to “time” market movements, inadequate diversification, the payment of high and unnecessary fees to managers and advisors, and the use of borrowed money can destroy the decent returns that a life-long owner of equities would otherwise enjoy.”
In other words: beware of Intervention Bias and other System One modes of thinking, stick to your System Two long-term financial plan – and stay far away from whatever the crowds happen to be chasing today.
Alan MacDonald an investment advisor with Richardson GMP Limited, helps investors with over $500,000 of assets make smart decisions about money. Alan is the co-author of “The Copperjar System, Your Blueprint for Financial Fitness” available on Amazon.
For more information please visit www.alanmacdonald.ca or email Alan at Alan.Macdonald@RichardsonGMP.com.
All material by Alan MacDonald, Investment Advisor at Richardson GMP Limited. The opinions expressed in this article are the opinions of the author and readers should not assume they reflect the opinions or recommendations of Richardson GMP or its affiliates. Past performance is not indicative of future results.
Richardson GMP Limited, Member Canadian Investor Protection Fund. Richardson is a trade-mark of James Richardson & Sons, Limited. GMP is a registered trade-mark of GMP Securities L.P. Both used under license by Richardson GMP Limited.
