There’s an old joke that marriage is picking the person you’ll spend forever asking, ‘Any thoughts on dinner?’
What to eat is just one of an estimated 35,000 decisions humans make each day.
To make decisions more efficiently humans use heuristics or mental shortcuts. Heuristics are used to make inconsequential decisions but also to reduce the cognitive effort of solving complex problems. That is where the problems start.
Heuristics often lead to errors. Behavioural research shows the errors are not random and instead follow a predictable pattern.
In the investment world most studies are done on individual investors. But in 2018 a group of behavioural researchers looked at the decision making of expert investors.
The results are surprising. Expert investors make good decisions when they buy new securities. But their selling decisions are so bad their investment performance would improve by randomly picking what to sell. That is not the type of results you’d expect from experts.
What the research shows
The paper titled Selling Fast and Buying Slow: Heuristics and Trading Performance of Institutional Investors was written by Akepanidtaworn, Di Mascio, Imas and Schmidt.
The data set was institutional investors with portfolios averaging $573 million in assets under management. A total of 783 portfolios and 4.4 million trades between 2000 and 2016 were analyzed.
To assess the decision making the researchers used counterfactuals or alternative options the portfolio manager could have taken. For both buy and sell decisions the counterfactual assumed the manager had no skill. The absence of skill in decision making is to randomly select what to sell or buy.
The differences between decision making on buying and selling is stark. The study showed that the positions the portfolio managers bought outperformed the benchmark and the strategy of random buying.
When picking what to sell the portfolio managers significantly underperformed the random sale of an asset in a portfolio. Returns were lowered between 0.50% and 1.00% annually due to poor decision making when selling assets.
Why the difference between buy and sell decisions?
In theory there should be no difference between the results of a buy and sell decision. Both require an estimation of future returns on individual securities. A skilled investor will purchase the securities with the highest expected returns and sell securities with the lowest expected returns.
The researchers attribute the disparity to the different levels of effort put into each decision. Portfolio managers spend more time figuring out what to buy than what to sell. This does make sense.
Buying decisions are subject to scrutiny and the holding shows up in performance reporting. The opportunity cost of selling a security takes more effort to evaluate and once something is out of a portfolio it is largely ignored.
Like all humans trying to make complex decisions in an efficient way, portfolio managers rely on heuristics to decide what to sell. In this case something called a salience heuristic.
A salience heuristic refers to our tendency to disproportionately focus on more prominent or emotionally jarring information instead of considering all data objectively. When considering what to sell the portfolio managers focused on positions with the most extreme returns – both up and down.
The data showed extreme positions were 50% more likely to be sold than those with more moderate returns. The greater the tendency of an individual portfolio manager to follow this pattern the more the manager underperformed the random selling counterfactual.
This pattern was not evident at all in buying decisions where portfolio managers spent more time and carefully considered all available options instead of relying on a heuristic.
How does this impact individual investors?
Individual investors tend to exhibit the salience heuristic on both buy and sell decisions which further lowers returns.
Logically it makes sense that investors focus on more extreme returns. Most individual investors spend less time investing than professionals and tend to focus on investments that are frequently reported in the media where extreme returns get more attention.
This is called the availability heuristic and describes our tendency to focus on things that immediately come to mind. There are many examples outside of the investment world.
Murders are frequently reported in the media and people assume they are more prevalent than suicides which tend to be more private. Yet in Australia the ratio of suicides to murders is roughly 13 to 1. This also explains why people fear low probability events like shark attacks or plane crashes far more than higher probability events like car crashes.
Individual investors also tend to suffer from a disposition effect which increases the likelihood that winners are sold too soon and losers are held for too long. Known as cutting the flowers and watering the weeds, loss aversion refers to the avoidance of realizing a capital gain by selling.
Avoiding the impact of poor behaviour
When I first started investing, I assumed that most professional and individual investors were getting great results. Professionals sounded sophisticated and could articulately explain the rationale for their actions. Most of the stories I heard about – and from – individual investors involved their winners.
I’m much more skeptical now because the data doesn’t add up. Most professionals don’t beat the passive equivalent and every study I’ve seen shows individual investors in aggregate get poor results. In this edition of Firstlinks Larry Swedroe outlines more data on poor individual investor outcomes.
These poor returns are largely the result of self-sabotage. Understanding the predictable pattern that investors follow in these acts of self-sabotage is helpful. Seeing the data about how poor returns are helps. But improving decision making means replacing heuristics with more deliberate and analytical decision making.
Adding structure to the investment process by setting goals and creating a plan lay the foundation for better decisions. But slowing down decision making is also crucial. The results of the study on expert investors show what happens when time and attention is in short supply. Slowing down decision making reduces the likelihood you will rely on a heuristic.
As I’ve gained experience I’ve learned to take my time. I’ve figured out that my mistakes come from feeling an unwarranted sense of urgency. The frenetic pace of markets makes it appear as though opportunities are short-lived. In rare cases this is true, but most people are hurt far more by rushing than by missing out on opportunities.
Write down the rationale for making an investment, sleep on it, and revisit your thesis.
Call a mate and explain why you think a particular investment is a good idea.
Do whatever it takes to lower the influence of heuristics and increase the rationality in your decision making. It might just improve your outcomes.
Mark LaMonica
Also in this week's edition...
We still don't have details on the government's proposal to change the CGT discount but that hasn't stopped the debate from continuing. Jago Dodson and Liam Davies propose an approach that supports home ownership and discourages speculation.
When the weight loss drug Ozempic hit the shelves the markets quickly - and ultimately unjustly - punished several shares including ResMed. Ron Shamgar argues the same thing is happening now to software as a service shares.
Meg Heffron has been helping the Firstlinks community understand the implication of the Div 296 tax in a series of articles. In her last article on the subject she lays out the case that doing nothing is likely the best option for investors hit with the tax.
Everyone is talking about bubbles but according to Joachim Klement they last far longer than we think and are impossible to spot in real-time.
Anthony Tutrone and Chris Bokosky lay out six major themes that will impact private markets for years.
A study tracked the fortunes of four different types of investors and things didn't look good for individuals. Larry Swedroe outlines six ways to improve your odds.
The prevailing negative narrative about Melbourne is missing out on the strengths of the city according to Manning Clifford.
This week's white paper is the World Gold Council's 2026 edition of Gold as a Strategic Asset.
Curated by Mark Lamonica and Leisa Bell
A full PDF version of this week’s newsletter articles will be loaded into this editorial on our website by midday.
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