The importance of mental models (part two)

In the previous essay, I described the game/contest mental model for making investment decisions and detailed many of the problems that result.  The model’s inherent problems are due to how it simplifies an overwhelming choice of options in a manner that ignores too many important aspects of the investment landscape.  Let’s revisit the three critical questions and develop a better mental model.

  1. What to own
  2. When to buy or sell
  3. How much to invest in any single investment

What to own: Instead of choosing only securities we “understand,” a better question to ask is should we invest in a broad or narrow set of securities.  From this perspective, the choice is obvious.  As I have previously stated in numerous other essays, the chance of any investor to choose a set of securities that outperforms market averages is well less than 50%.  Choosing someone (like an adviser or fund manager) who will be likewise be more successful than overall averages is not any easier.  Instead, choosing a broad set of securities insures better (but not the best possible) performance.  Because of wide diversification, such a choice insulates the investor from the worst performing securities or sectors of the market.

When to buy or sell:  Rather than choosing a poorly-defined holding period that does not match the investor’s time horizon, a better option is to choose a time period that does match.  This time horizon should be thought of essentially forever (or at least as long as an optimistic scenario for the investor’s life expectancy).  When this perspective is taken, the choice of securities is narrowed significantly.  The question to ask is, “Am I comfortable holding this investment for the rest of my life?”  As was the case in the previous paragraph, owning narrow-based securities, such as individual stocks or a Brazilian small-cap stock fund would not be appropriate.  Owning a very broad set of securities like the entire U.S. stock market would be a much better choice.  If you plan on holding a security for the next 50 years, you should also make sure that the costs to hold such a security are as low as possible.   Even small costs add up over many years.

How much to invest in any single investment:  Instead of letting the whims of the market determine how much is invested in a particular type of security, this should be a conscious asset allocation decision determined beforehand.  Asset allocations should be kept constant, rather than being allowed to drift with the market fluctuations.  I discuss this principle in detail in an earlier essay, “The importance of a fixed asset allocation.”

The idea that the value of the various securities in your portfolio should be based on the amount you decided to invest initially and then adjusted by whatever price action occurs afterwards is rather bizarre.  When expressed this way, it demonstrates how random the game/contest-based process is compared to what would be considered a more rational process in which you keep better control over those proportions.

Keeping the same number of shares (a typical way to reducing decision options) while markets fluctuate will ensure that a portfolio will become dominated by the securities that have had the best short-term performance.  This is fine until the trend changes and the formerly best-performing securities underperform and other securities take their place.  As markets gyrate, a rule that keeps asset allocations constant forces the purchase of underpriced and relative cheap securities and the sale of overpriced and relatively expensive securities.

Owning a security forever does not mean never making any changes.  The amount, measured as a percentage of the entire portfolio, should be held constant, but the actual number of shares will fluctuate along the market.  This will require buying and selling to keep allocations constant, otherwise known as rebalancing.

The problem with the game/contest model is primarily that it does not work well.  With an undetermined time frame, investors rely on emotions of pride, regret, fear, greed, confidence, anxiety, etc., to make selling decisions.  This usually leads to trouble.  The model is flawed due to a mismatch between the model and the entity being modeled.  By changing the assumptions about what types of securities to own, the time frame, and the amount to be invested, it leads to a different way of thinking about how to manage a portfolio.  The Cognitive Investing model leads to asking a completely different set of questions and forces the investor to focus on controllable elements of the decision making process instead of uncontrollable elements and emotions.

Investing is not a series of discrete events, but a continuous process that lasts as long as you have a portfolio.  It is not something you do from time to time.  It is something that goes on all the time.  You may not be making decisions about what to buy or sell every day, but the process goes on.  The mental model for investing should reflect the continuous nature of the process.

Another problem with using an inappropriate mental model is that it tends to suppress information that does not conform to the model.  For example, if you think investing is about stock picking and not decision-making, you will filter all information so that information relevant to stock picking gets through and information about decision-making is blocked. You stop considering choices you should make like making adjustments mid-way through the game.  You cannot add to your bet in blackjack in the middle of the hand.  You cannot increase or decrease your bet on a horse midway through the race.  Because these options are off the table in the game world, investors do not consider them in the investing world, and their portfolio’s performance suffers as a result.

For an example of how a portfolio managed with the Cognitive Investing mental model works in practice, examine the demonstration portfolio on this web site.  The choices of investments in the portfolio are suitable for ownership for many years.  The allocations are adjusted quarterly if market fluctuations cause the components to diverge too far from their targeted allocations.  Transactions are infrequent, keeping costs low.  Low-cost exchange-traded funds are used to provide broad diversification at reasonable expense.  Emotions are absent from the decision-making process.

The Cognitive Investing model is flexible.  Modifications to the portfolio can be made along the way if the investor’s personal situation changes dramatically (such as getting a divorce or receiving an inheritance), if a security can be replaced with a better choice, or if a security disappears for some reason.  But this framework for decision-making forces better choices by better matching the characteristics of the underlying landscape.  It removes the need to continually consult and pay an advisor a yearly fee or pay a broker a transaction fee to end games that did not work out very well and start new ones.

So, even though the choices faced by investors are daunting, the Cognitive Investor has a mental model that simplifies these choices in a way that streamlines decision-making and increases the odds for investment success.  It helps to remove the influence of emotions, which frequently lead to poor investment choices.  It simplifies the investment landscape in a way that does not ignore some of its most essential features.  And it focuses the investor’s attention to aspects under his control instead of having his decisions being unduly influenced by external events.

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