Through experience you have most likely realised that the human mind was not made for the world we are living in. Scientists have also proved it.
It was made for a time when quick decisions, fight or flight, was to our advantage.
Not for now when problems creep up on us over extended periods of time or when we have to gather information and make decisions over long periods of time.
I know I don’t need a scientific study to tell me that I sometimes make mistakes when deciding, don’t we all.
For example when investing I realised that I often made the mistake of hanging on to losing investments and selling profitable ones too soon. It was frustrating and I decided to do something about it.
I had to look quite long but eventually I came across the, then new field of research, called behavioural economics.
Behavioural economics tries to understand the economic decisions we make and why we make them.
What it found was with awareness and certain tools there are ways you can improve our decision making.
And this is what this article is all about, tools to help you make better decisions. Keep reading to the end of the article for a handy checklist you can you to improve your thinking.
Or more specifically my interpretation of an excellent paper written by an Australian university professor and two consultants from the well known McKinsey consulting company called Learning to let go: Making better exit decisions.
The paper is really about how companies can make better decisions on selling or closing loss making investments. However the problems and their solutions can be used more widely.
I can really recommend that you read the whole article by clicking on the link above or by going to the McKinsey website (free registration required)
So how can you make better decisions?
Mistakes made when analysing an investment
Problem – The confirmation bias
This is your natural tendency to, once you have made up your mind, only seek information that supports your thinking.
But looking only for information that supports your thinking does not help you make a better decision it only gives you more reasons to support your decision even if it is wrong.
The confirmation bias is best countered by keeping an open mind but most of all by actively looking for contradictory information that does not support the direction you are thinking.
The article suggests that existing management be replaced as new management will look at the investment with new eyes. Or that a company creates additional accountability by having someone who was not part of the original project or decision sign off on the decision and also hold this person responsible.
Both are good suggestions but not really practical for you to use with your investments.
Here is what I do.
With my investments I look for opinions different to mine on the internet or I ask a friend to look at an investment and force myself to consider his opinion especially if he disagrees with me.
I say force myself because frankly it is difficult to do. I caught myself trying to ignore or argue against his opinion before I even finished reading it!
Problem: Anchoring and adjustment
This bias in thinking leads you to adjust your fair value calculation to get a price as close to the current price the investment is trading at.
The current price of an investment is irrelevant when you are calculation the value of an investment but it is difficult to ignore.
What studies have found is that investors skew their calculations so that their valuations are close to the current price as possible.
Countering this thinking trap is quite easy if you know what to do.
As the price is difficult to ignore, rather that trying to calculate the value of an investment, calculate in the other direction. This means calculate what assumptions are built into the current price.
For example what free cash flow or earnings growth rates are assumed to get the current price. Once you have these compare them with your forecasts for the company and see if they fit.
Mistakes made when deciding to sell an investment
Problem: The sunk cost fallacy
The automatic leaning you have to think about the price you paid for a losing investment. The price you paid is irrelevant when deciding to keep an investment or not. It is merely a price from the past that you happen to have payed for the investment.
As you cannot sell the investment for the purchase price it is irrelevant.
The best way you can counter this trap is to set up a roadmap when you make an investment. The roadmap is to clearly show what you expect will happen to the investment in future.
For example the company has to have a 10% increase in sales in a years time and another 15% the year thereafter.
Should you reach a date and not have achieved the expected results it makes it much easier to identify a failure on the part of the company and sell the investment.
This technique also prevents you from changing the decision criteria as time progresses.
My best example of this mistake is a short term speculative investment I made, in what I thought was a takeover target, which turned into three year investment that I eventually sold at a loss.
Have you signed up for my free weekly newsletter "Investing that makes sense" yet?
Sign up now and receive articles like this in your inbox weekly.
And if you sign up now you will also receive a 10 page free bonus report – Enhanced Checklist for Value Investors – with over 30 proven checklist items to improve your investment returns.
Problem: Escalation of commitment
The tendency humans have to invest more money in an investment even when all indicators point to a loss of the additional investment.
Some times buying more of a losing investment can be a great investment. My painful experience has however been that the funds are most likely better invested elsewhere.
I now hardly ever buy more of a losing investment. I follow a strict stop loss system where I immediately sell an investment that has exceeded my pre-defined loss level, usually a 20% to 25% loss.
And I must say even this is difficult to do.
The problem with these thinking mistakes is that you are not aware them.
But now that I have pointed them out I am sure you realise that you have made some of them, as I have. The only way to overcome them is to be aware of them and use the above suggestions.
To improve my thinking I have made a short summary of this article which I review every three months to keep the ideas fresh in my mind.
I am still not 100% there but it is helping.
Give it a try, even if you can only implement and remember one of the recommendations you would already have improved your thinking.
I've put the following checklist together which you may want to keep handy to assist you in your decision making.
Checklist for better thinking:
- Actively look and consider opinions different to yours
- Keep an open mind, and hold your opinions lightly
- Calculate backwards from the current price. Ask yourself what assumptions are built into the current share price
- Be very careful before investing more in a losing investment
- Did the investment meet your expectations set when you bought it? If not think hard about selling rather than create new reasons to hold a losing investment
- When evaluating a losing investment remember the purchase price is irrelevant
Read more on how you can improve your thinking in the article Top 5 Investment Thinking Traps Exposed