A recent study into the psychology of investing reveals a glaring oversight in our approach to assessing opportunities. Bengt Saelensminde explains why sometimes it's better to use a different strategy.
Recently, we had a long and boozy French lunch. A wonderful argument erupted, and it's one that probably affects you.
My old mate Simon was explaining how "a bird in the hand is worth two in the bush" to his neighbour, Thierry. I don't know if it was a language or a philosophical problem, but Thierry wasn't having any of it.
Why would you be happy with one when you can have them both? With my shotgun... etc, etc. And the longer the conversation went on, I began to understand what Thierry was going on about. And there's a lesson here.
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Our instincts are set up to accept a bird in the hand. But more often than not, we would be far better off going for the two in the bush.
The Frenchman has a point
A recent study into the psychology of investing certainly backs Thierry up. The experiment by Shiv, Loewenstein and Damasio goes like this.
They gave volunteers 20 one-dollar notes each and said all they have to do is put a dollar down on the flip of a coin. There'd be twenty rounds and the idea was to amass as much money as possible.
Now, to make the study interesting, they said that heads wins you $2.50, but tails means you lose a dollar. You have a choice as to whether you bet or sit out on any round.
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Of course, if anyone's stupid enough to offer you this bet, you should take it every day of the week. For a fifty/fifty chance, you've got a chance of getting more than a 50% return. Statistically, if you bet every round, you'll end up with $25.
So it was interesting to see how people 'really' behaved.
It turns out that most of the volunteers bet on less than 40% of the rounds after a losing round. The longer they got into the game, the more anxious the volunteers got. And they sat out more and more rounds.
This irrational behaviour comes from the fear of losing money. The pain from a loss is greater than the pleasure from a win. And this sets us up to make the wrong investment decisions.
Thierry's logic tells us to make a calculated risk and see if it's worthwhile holding out for two birds. Have you got a better than fifty/fifty chance of getting both birds? Do you have a shotgun?
You need to work out the odds for yourself
As I keep saying it's up to us to take responsibility for our own savings. A lot of investors will have been burned badly in recent years.
And the memory of those losses will be very painful. The temptation now is to defer to the opinion of a financial adviser. To let him reckon with the dangerous odds of investing.
But no financial adviser has a crystal ball. In fact, like a quack mystic, it's in their interests to make you think that they can see how your investments will pan out.
The truth of the matter is that nobody can tell you how any financial savings are going to fare.
The key here is to get the optimal risk/reward balance for YOU. It all comes down to what the pros call asset allocation. That is, how your portfolio is spread into different assets like shares, bonds, commodities and currency (and how it's geographically spread too).
Time and time again, I look at portfolios where hardly any thought has gone into asset allocation. And yet this is the most important way of getting the right risk/return balance right.
It's time to assess whether it's worth taking the bird in hand, or getting your shotgun out and punting on bagging two.
Sign up to The Right Side and in our next issue, I'm going to show you how to assess your asset allocation and how you can use it to help get your risk/reward balance right.
ETF's performance relies on the performance of the underlying investments. Your capital is at risk when you invest in shares - you can lose some or all of your money, so never risk more than you can afford to lose. Always seek personal advice if you are unsure about the suitability of any investment. Past performance and forecasts are not reliable indicators of future results. Commissions, fees and other charges can reduce returns from investments. Profits from share dealing are a form of income and subject to taxation. Tax treatment depends on individual circumstances and may be subject to change in the future. Please note that there will be no follow up to recommendations in The Right Side.
Managing Editor: Theo Casey. The Right Side is issued by MoneyWeek Ltd. MoneyWeek Ltd is authorised and regulated by the Financial Services Authority. FSA No 509798. https://www.fsa.gov.uk/register/home.do
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Bengt graduated from Reading University in 1994 and followed up with a master's degree in business economics.
He started stock market investing at the age of 13, and this eventually led to a job in the City of London in 1995. He started on a bond desk at Cantor Fitzgerald and ended up running a desk at stockbroker's Cazenove.
Bengt left the City in 2000 to start up his own import and beauty products business which he still runs today.
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