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Tips for investing in an uncertain world

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Tips for investing in an uncertain world

Investing is not a simple process. It involves drawing conclusions from incomplete evidence in an ever-changing world. But if we think about how our minds work when confronted by these uncertainties, then we are taking an important step to making better investment decisions.

Imagine you are a contestant on a quiz show along with an unknown number of other contestants. You are all presented a series of statements about a person, one statement at a time, and the first contestant to draw the correct conclusion about the person wins the prize. Each contestant gets one chance, so if you arrive at the wrong conclusion, you’re out. The statements begin with:

“Sam heard the alarm.”

At this point, most contestants would agree that there is insufficient evidence to draw a conclusion about Sam. He could be doing anything, anywhere within the vicinity of an alarm—in bed, in an office building during an evacuation, breaking into someone’s property, or any number of other places and activities. Perhaps you picture him lying in bed at 6am, because that is your most recent or familiar interaction with an alarm.

“She went downstairs for breakfast.”

This statement confirms that Sam was in bed, so your initial hunch was right. But wait a moment—Sam is actually female, not male! You’ve uncovered a piece of evidence that contradicts your initial assumptions about Sam as a person, which were based on a recollection of your previous experiences with “Sams” (availability/familiarity heuristic). Feeling unsettled, you decide to wait for the next statement (searching for more evidence).

“She was worried about class.”

So now you know that Sam goes to school, and in your mind you picture a girl coming down a flight of stairs, sitting down at the kitchen table and anxiously eating her cereal or toast. Perhaps a concerned parent asks her if anything is wrong. The only question that remains is, what kind of school is she going to? Is she going to primary school or high school, or perhaps even university? Based on the statements above (the evidence you’ve collected), you conclude that she is most likely in high school, because if she was in primarily school she might not yet use an alarm, and if she was in university there’s a lower chance that she still lives at home. Given what you know, this is a reasonable conclusion and you decide to press the buzzer, answering that Sam is a teenage girl attending high school. In an investing context, perhaps high school would be your base case, with primary school and university as other scenarios.

“She wasn’t sure if she would be able to control them.”

Did the possibility of Sam being a teacher cross your mind at any point during the above process? This new piece of evidence could represent an unknown unknown, a known unknown that you hadn’t contemplated, or simply the result of a lazy research process—you had sufficient evidence for your mind to jump to a cohesive conclusion, and not wanting to miss out on a potential winner, you stopped your research process prematurely. Your time spent deliberating between primary school, high school and university was for naught because the entire thesis has changed in light of previously overlooked evidence.

At this point, some investors might persevere with their investment by trying to downplay or explain away the contradictory piece of evidence (confirmation bias) because they’ve already invested a substantial amount of time and mental resources into the research process (sunk cost fallacy). Other, more prudent investors would exit their investment as the new evidence no longer supports their original thesis, recognising that if they held on to their position, they would effectively become speculators.

The Montgomery global team recently attended a mindfulness course during which a version of this exercise was conducted. While not specifically targeted at investing, the lessons from this exercise have far-reaching implications for investors. The human mind demands order, coherence and certainty. This urge to explain things drives us to take the evidence in front of our noses and form judgments without considering the quality or completeness of the evidence.

Ultimately, investing is about drawing variant perceptions from incomplete evidence. However, to avoid jumping to conclusions, investors need to consciously control their intuitive, subconscious decision making system and learn to live with varying degrees of uncertainty.

Daniel Wu is a Research Analyst at Montgomery Global Investment Management. Prior to joining Montgomery in June 2016, Daniel was an analyst in the investment banking divisions of UBS and Goldman Sachs, where he covered the Infrastructure, Utilities, Technology and Media sectors.

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This post was contributed by a representative of Montgomery Investment Management Pty Limited (AFSL No. 354564) and may contain general financial advice that is prepared without taking into account your personal objectives, financial circumstances or needs. Because of this, before acting on any of the information provided, you should always consider its appropriateness in light of your personal objectives, financial circumstances and needs and should consider seeking advice from a financial advisor if necessary.

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