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Inherent risk - The human mind has not evolved to make the best investment decisions

11/02/2013

Kevin Murphy

Kevin Murphy

Fund Manager, Equity Value

The human brain is a funny thing and works in ways that are not always sensible and rarely easy to understand. As a way of addressing this point, the Nobel prize-winning behavioural theorist Daniel Kahneman has written about ‘system one’ and ‘system two’ – what we might effectively think of as the subconscious and conscious parts of the human mind.

According to Kahneman, our ‘system one’ subconscious reacts and makes decisions automatically for a variety of sound evolutionary reasons and does so with little effort or indeed understanding on our behalf. Our ‘system two’ conscious meanwhile is involved in all our deeper thinking but is also inherently lazy and would rather do nothing if an instant judgment is available from our subconscious.

When we are asked a difficult question, therefore, we will often subconsciously ‘flip’ it so that, while only subtly different, it is considerably easier to answer. ‘How happy are you with your life these days?’ Is actually a tough question that involves a degree of thought so we subconsciously jump to a slightly easier one – ‘how is my mood right now?’

Similarly, if you were asked how popular David Cameron is likely to be going into the next general election, you would not really weigh up everything that might and might not happen between now and 2015. Instead, your mind would factor in how popular Cameron is today and extrapolate from that. Even if you are not addressing the question actually posed, your subconscious does this without you realising and the conscious part of your brain does not debate it enough to bother putting up a fight.

Bringing this all into the world of investment , this means when someone is asked whether they see Tesco, for example, as a good investment, their answer is more likely to address the subtly different question of how they ‘feel’ about Tesco. Depending on who they are that might lead them to focus on, say, the group’s us strategy or the fate of its smaller competitors or even the precise contents of its burgers but, in all likelihood, their answer will be based more on emotion and gut reaction than the altogether trickier matter of whether Tesco may or may not be a good investment.

The real answer to whether Tesco will be a good investment will, of course, be dictated almost entirely by numbers yet the human brain prefers not to get involved with such complexities. It will switch instead to more ‘touch-feely’ considerations such as brands or pricing power or logos or indeed, in modern-media terms, anything that can be illustrated with a pretty picture. That is all fine when it comes to filling the pages of the financial press but it is irrelevant in the assessment of the potential quality of an investment.

As we never tire of repeating on the value perspective, the key considerations as to whether or not a company is likely to be a profitable investment are its valuation and the health of its balance sheet. Such an approach may not make us the most entertaining interviewees or even popular with marketing people but it is this, more difficult, side of the job that will dictate whether or not we are successful in what we do. Understanding both that and the limitations of the human brain are the first steps to being able to circumvent some of the mental shortcomings that have evolved in us all as human beings.

 

Author

Kevin Murphy

Kevin Murphy

Fund Manager, Equity Value

I joined Schroders in 2000 as an equity analyst with a focus on construction and building materials.  In 2006, Nick Kirrage and I took over management of a fund that seeks to identify and exploit deeply out of favour investment opportunities. In 2010, Nick and I also took over management of the team's flagship UK value fund seeking to offer income and capital growth.

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