Using a journal to beat hindsight bias

Even before the year is over, investors are looking to 2012.  Forecasting is what the industry likes to do in the festive season. But, is there something more useful to do in December, something that might be more help to 2012 performance than predictions?  It is not too late for investors to learn from 2011.  The lessons are not just about the folly of forecasting – the Arab Spring surprised the strategists before the end of January.  The key market message this year is that psychology matters. 

 Lower trading volumes, but increased volatility were this year’s stockmarket features.  Investors realised that it was not enough to focus on risk and return, but stress and anxiety need managed, too.  Buying a stock for a big projected gain achieves little if share price volatility then triggers a premature sale. 

 For example, oil services business, Wood Group, has gained 20% in the year, well ahead of a weak stockmarket.  But many investors sold during the summer setback when the shares dropped 25% in two weeks.  And, there were eight days on which the shares fell more than 5% – matched by as many extreme positive days.  Many of the other growth businesses that have outperformed in 2011 delivered a similar rollercoaster ride; for example, ARM, Burberry and Weir Group.

 It can be hard to maintain focus on the destination if the journey proves too difficult.  Even the most rational investor can be unnerved by fellow travellers in a stock if they have different time horizons and risk tolerances.  Most find it a challenge to keep faith with a company if its share price persists in ignoring fundamentals.  This anxiety triggered a lot of the unhelpful trading this year that did so much damage to portfolios.  The response of many investors to this anxiety has been to seek comfort in defensive stocks, but with low conviction. 

 In 2011, investors may not have got what they wanted, but they did get experience that can be put to good use.  However, it requires an unemotional, objective analysis of what happened.  Trading activity needs to be calmly and critically examined, and the lessons learned for next year.  Did changes during the year add value?  How far has an investment plan shifted from the strategy set out last January? 

 Simply using recollections to review the year is dangerous.  Memory fails us.  Hindsight bias is a human failing that makes us think we knew it all along.  We can attempt to rationalise our decisions made earlier in the year, without now recognising the extent to which emotion was involved.

 A key way to bring objectivity to this appraisal is to maintain an investment journal. The simple act of keeping a notebook documents in black and white exactly what drove any change in position. Without a record, it is too easy to take a rose-tinted view of events.  But, with objective hindsight, an honest assessment is possible and lessons can be learned.  In theory, dealing history is available from institutional administration systems.  However, although this provides the numbers, it will usually be missing the reasoning at the time, and what went into a judgement.  These are better captured in a personal log, which is also something we are more likely to trust.

 Analysis of a journal should set up a revised investment strategy for 2012, and also a useful set of investment rules.  The best rules are those that arise from painful experience; the pain of loss and regret is at least twice as powerful as success.  A record may make uncomfortable reading, but the process is an important part of learning and improvement.   Investment professionals should focus as much on history as on projection.

Behavioural finance is often criticised for its impracticality; challenging the neat modelling of traditional finance, but not offering a complete solution.  But it does have some answers; they just need to be more tailored to the psychology of each individual investor.  Recognising that the current market turmoil could persist through 2012, is good reason to develop a strategy to match that.  Maintaining a dealing record, and learning from it, is a good resolution for the new year.

This article is for informational purposes only. The opinions in this article are the author’s own. The information presented in this article has been obtained from sources believed by the author to be reliable, however, he makes no representation as to their accuracy or completeness and accept no liability for loss arising from the use of the material. Colin McLean may have an investment in any of the companies mentioned in this article.