Michael Falk, CFA of Focus Consulting Group Inc. in Chicago, explained at a recent CFA Society Toronto luncheon seminar how biology affects human decision making and why it is necessary to put a mirror to our own thought processes if we are to make successful investment decisions. Starting from the perspective that capital markets reflect human behaviour and are biological constructs (not efficient economic valuation mechanisms), he gave detailed practical advice on how investment managers can improve their performance. Falk explained how human beings strive to “fit” new information into existing knowledge in such a way as to support our existing biases and increase levels of dopamine in our brains. Dopamine is a powerful organic chemical and neurotransmitter that helps control the brain’s reward and pleasure centres. Citing numerous well-documented examples of the effects of musical, visual, and emotional distractions, decision fatigue, and even the weather on investment and other decisions, he prescribed a practical course of action for dealing with our own psychology and learning from it.

“He who knows others is wise; he who knows himself is enlightened”
– Lao-Tzu, founder of Taoism

Practical advice on analyzing our own investment psychology

Firstly, we must recognize that

• we are not “wired” for successful investing;
• we can benefit from creating and following investment policies and processes;
• we can also benefit from understanding our investment environment and appreciating that we bring numerous psychological biases to our attempts to deal with it;
• we can improve our investment performance by making fewer, more carefully thought out investment decisions, waiting if necessary for the investment “fat pitches” (a baseball analogy meaning an easier ball to hit well);
• we should be wary of making hasty investment decisions based on new, undigested information or opinions, particularly at times when our thinking may be compromised by emotions or other cognitive distortions; and
• most importantly, we can benefit from keeping an investment journal and trying very diligently to learn from it.

The value of keeping an investment journal

Investment journals can be used to record the date, price, nature (buy/sell), justification (e.g., details of attractive valuations, expectations of price catalysts or promising price momentum) of all investment decisions; level of confidence in taking the decision; and potential influences on the investment manager’s frame of mind at the time (e.g., recent receipt of a large year-end bonus, suffering from a winter virus, heard bullish/bearish presentation in the office, the weather, etc.).

The journals are best used when they contain space for reviews showing returns achieved to date and “post mortem” analyses revealing the truth or fallacy of the initial investment justifications. The journals will show whether or not the manager’s investment decisions are adding value and if his or her frame of mind could be having a bearing on the success or failure of decisions. Recurring patterns of successes or failures should in time become apparent, and this will help the investors to become better at their craft, assuming they make the requisite changes in their patterns of behaviour.

The journals may even reveal particular skills or deficiencies in valuing securities, picking growth stocks, understanding catalysts and momentum in share prices, sourcing good investment ideas, and/or being an adept contrarian. This would indicate what investment roles particular individuals should pursue to optimize their comparative advantages and how investment analytical and management responsibilities in a firm can best be deployed among its people. This deployment would tend to optimize investment manager/analyst teams in a similar manner to the way that portfolios of securities may be optimized. With fewer than 10 percent of investment management firms estimated to be reviewing their performance in this way, Falk maintains that the potential for gaining competitive advantages by doing so is very significant.