Should investors “trust their gut”?
Luke Skywalker: “I have a bad feeling about this.”
We make dozens of decisions every day. Most are inconsequential–“Should I wear black or brown socks? Should I have toast or grapefruit for breakfast?” Sometimes they’re critical, like who to hire for a new position. To help us make decisions, we use informal rules, or heuristics—like drawing a picture, or solving an easier problem first. Often, we draw on experience. If I see a set of flashing blue lights on the highway, I know I need to slow down.
Investors make decisions about their portfolios all the time: does the mix between stocks, bonds, and real estate in my portfolio need revising? Is this company over or under-valued? Is the market at a turning point? All these decisions potentially have significant financial consequences. And just leaving a portfolio alone is a decision. Not to decide is to decide.
“Girl with a Book” by Jose Ferraz de Almeida Junior. Source: Sao Paolo Museum of Art.
Frequently, we use intuition—drawing on a mix of experience, inference, and analysis—to guide us. But how successful are our “gut feelings”? When we measure the outcomes, intuition is less effective than we think. That’s because we tend to look backward selectively—remembering the good choices, forgetting our errors. And we become overconfident.
So it’s important to have a disciplined process. An elite army combat unit was choosing new members and had the interviewers focus on just one topic, rating each candidate on a 1 to 5 scale—just in their one area of expertise. Interviews done this way were much better at predicting subsequent performance than the old, free-flowing discussions—which had no predictive value.
The problem with intuition is that it comes too fast. We form our judgements before we have a chance to consider all the data. We think that what we see is all that there is, we form a verdict, and then we look for information that confirms our conclusion and ignore any dissonant data—all in a flash. It’s why our brains are subject to optical illusions. We think too fast; we need to slow down.
Optical illusion. Source: Wikipedia
That’s why investment rules usually outperform subjective judgements. Whether it’s to rebalance a portfolio or sell a stock at a certain point above its fair value, a rule has no prejudice and no selective hindsight. But because the world is dynamic, rules need to be updated. What worked in the past won’t always work in the future.
When it comes to investing, Obi-Wan Kenobi was wrong: we can’t just trust our feelings. The only investment-force is sound judgement, backed up by rigorous, disciplined analysis. Snap decisions are the “dark side.”
Douglas R. Tengdin, CFA
Chief Investment Officer