Blogs | October 27, 2017

How to steer a straighter course when investing

Odysseus outfoxed the sirens by tying himself to the ship’s mast. You can cut other risks this way, notes Chris Dillow.

Everybody likes to point out that economists are terrible forecasters. They’re right: economists have consistently failed to predict recessions. This, however, misses something important – that people are lousy forecasters of their own personal circumstances.

A team of US economists have found evidence for this. They’ve found that American houses with swimming pools cost an average $1,400 more in the summer than in the winter, and that convertibles are highly priced relative to four-wheel drive cars in the summer, but cheaper than the latter in winter.

Projection into error
People don’t anticipate how their preferences will change. In the summer, we may fail to see that the swimming pool or convertible won’t be much use in the winter. And in the winter, we may not understand how much we’ll like them when the warmer months arrive. This is an example of projection bias: we tend to impose our current preferences on the future, even though they might change over time.

Economics professor George Loewenstein and colleagues say this causes many people to spend too much on expensive goods such as cars and TVs, because we don’t realise we’ll get used to them.

There are other examples of our failure to forecast. Just before the financial crisis of 2008, finance scholar Christoph Merkle asked UK investors how they would feel if they lost a lot of money. Most said they’d feel very bad. Yet afterwards, when they had lost a lot in the crisis, they said they didn’t feel as unhappy as expected.

Underestimating happiness
Economists Alois Stutzer and Reto Odermatt show that people who are about to get married overestimate their future happiness, whilst people who are about to suffer widowhood underestimate theirs. In all these cases, there’s a failure to anticipate our ability to adapt to new or different circumstances. We get used to changes – both good and bad – and so our happiness is more stable that we expect.

Almost three millennia later, that strategy still works.

There is another way our forecasting goes awry – weakness of will. If you’re anything like millions of others, you might buy gym membership thinking you’ll go regularly and get fitter. But in fact, you often stay at home instead. Or you might think about setting up a pension and saving, but there’s always a reason you never get around to doing so.

So we shouldn’t mock economists for failing to foresee the future; many of us are bad at foreseeing our own personal lives.

Steering your future self
Luckily, we can however reduce the cost of our inability to forecast. One way is simply to plan ahead. For example, the best time to buy summer goods such as barbecues and fans is often later in the year when they’re on sale. Equally, take care out shopping if you feel bad. So-called “retail therapy” can cheer us up, giving us a sense of being in control, but it can come at the cost of us spending too much, impoverishing our future selves.

How much stuff have you got in wardrobes or garages that you don’t actually ever use? If we can be recklessly spendthrift in our consumption choices, we can also be recklessly conservative in our investments, as Merkle’s work warns. If losses don’t hurt as much as we expect, perhaps we might invest more in shares and less in cash – particularly if you’re young and can potentially recoup losses by saving more over time.

Avoiding the rocks
Above all, though, we should get into the right habits. For example, I have set periods when I go to the gym, so I’m out of the house and on the cross-trainer before I’ve thought about it. Equally, saving and investing via direct debit removes the element of choice and can get us do the right thing without thinking.

In Homer’s classical epic The Odyssey the hero Odysseus, fearing the sirens would lure his ship onto the rocks, ordered his men to tie him to the mast so he couldn’t change course. Odysseus knew that a solution to being misled by temporary preferences can be to fix the right course in advance. Almost three millennia later, that strategy still works.

InvestingPresent biasProjection bias

Chris Dillow
Chris Dillow

Investors Chronicle writer and economist