The Role of Psychology in Investment

The argument could be made that prediction is at the heart of every investment decision. At a very high-level, you are providing capital to a company and predicting that you will earn a reasonable rate of return on your investment; however, this is by no means guaranteed. Morgan Housel from the Collaborative Fund wrote a blog post this week on the "Psychology of Prediction" and although it applies to many different fields, there are some key takeaways for finance and investment management. To begin with, its integral to understand that investing does not involve stable variables like in sports, such as golf or tennis. There is a much higher correlation between effort and skill because of the stability in rules and objectives, whereas in finance, outcomes can be overwhelmed by external tail events and participant behaviour that evolves over time. For further reading on differentiating between skill and luck, we would recommend reading Michael Mauboussin’s book on the topic – "Untangling Skill and Luck." Given the high existence of luck in investment management relative to other fields, prediction becomes about trying to tilt the odds of success in your favour. The reality for investors is that even with a strong process, where the probability of success is higher than failure, bad luck can trump a strong strategy in the short-run. The road to success is generally paved with agony, and as Housel opines in the post, “[l]osing faith after the inevitable losses that take place during sound, probabilistic predictions can cause people to quit predicting even when they’re technically good at it…Maintaining confidence during losses adds a whole different level of skill.”