How Greek mythology can make you a better investor

Nicholas Grove  |  07/12/2016Text size  Decrease  Increase  |  

Nicholas Grove: I'm Nick Grove at the Morningstar Individual Investor Conference in 2016 and I'm joined by Morningstar's Dr. Steven Wendel. Steven, what are some of the key behavioural biases that most afflict investors around the globe?

Steve Wendel: Absolutely. Unfortunately, there are many, but a few of them are particularly important. The one that we all struggle with and have the hardest time with often is overconfidence, the belief that we can beat the market. Of course, if you ask investors, all of them say that, which is impossible. And it takes us into risky positions, to risky sides of trades that we really shouldn't be getting into.

In addition to that we have a real challenge with what's seen as a recency bias that when we see the past performance of a fund, of a stock, et cetera, we believe that that is a natural predictor of the future. Because in everyday life, it's a great predictor. But in investing, of course, we know past performance does not predict future performance. The reason they have that is because we're hardwired to believe that it will continue in that way.

Now, in addition to that some of the other challenges that investors struggle with, what's known as descriptive norms or herding, which is, if you see a lot of people who get excited about a particular fund or stock, you naturally become so as well, which of course, in investing is a horrible idea. It means in many cases that the price has already been overbid and it's bad to enter. We see the same thing in reverse, when it's a terrible idea to exit when everyone else is as well.

Grove: And what are some of the strategies that investors can employ to overcome these biases? And I love the story and the concept of what you call the Ulysses contract. Can you just elaborate on that a bit?

Wendel: Sure. There are two main strategies. Ulysses contracts are about taking our moments of strength when we're planning out our investment strategy, when we're thinking through really what do we want to do in the future and then using that moment of strength to bridge us through to the moment of weakness, when we're likely to be tempted, when the markets are going crazy, et cetera.

And so, one example of the Ulysses contract is to, well, lock yourself in to a long-term investment and say, contractually, I cannot sell this for 10 years. Other ways of doing it are to create friction in your life to make it harder for you to make that foolish mistake. One would be to say if you're working with an advisor, for example, to have your advisor only honor your trades after three days or to require that your spouse be present. Added friction again makes it harder and you prepare by telling your advisor or telling yourself in some cases, all right, I can't do this without that extra time or extra person.

Grove: Steven, thanks for your time today.

Wendel: Absolutely. Happy to be here.

Grove: I'm Nick Grove with the Morningstar Individual Investor Conference in 2016.

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