Morningstar Interview with Jason Zweig

In these particular experiments I was being asked to engage in a probability guessing experiment that required a lot of conscious thought, much like playing a game of checkers or backgammon. Simultaneously, I was being presented with a much more basic stimulus, which was that I was getting little sips of sugar water. And there was a pattern to the sips of sugar water that my conscious brain paid no attention to because I was trying to solve the more complicated problem. But the unconscious part of my brain soon detected what was happening with the sugar water. And the next thing I knew, I was pressing madly with my right index finger to indicate that I had solved the problem, even though I had no idea how I had done it. And it was simply that the pattern of sugar water had started to repeat and that part of my brain recognized this repetition, while the conscious part of my brain was still searching for a solution.

That sort of thing goes on all the time in the financial markets. And individual investors do it, and financial advisors too do it, without realizing it. You may end up investing more in a particular stock because you saw the CEO on TV and his necktie was your favorite color. It sounds absurd to think that people would make financial decisions based on irrelevant factors like that but they do. And the reason they do is that things like colors and sounds and smells and tastes and associations with our past and with ourselves increase our comfort and familiarity with a frightening world.

These kinds of effects are everywhere, and they surround investors, and they shape a lot of people's decision-making without their ever realizing it. The reason I harp on this issue again and again is that the single most exciting frontier in contemporary psychology is the exploration of these unconscious biases and the fact that unconscious influences on our behavior can skew our decisions in ways that are incredible to people.

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Because of that, it's especially important to have really good decision structures. So the first thing is to have a checklist, and to study your past decisions, and to study the decisions of the world's best investors, and learn from your mistakes and theirs and come up with a set of criteria that every investment has to meet in order to be eligible for inclusion in your portfolio. I suggest a few in my book, but for individual investors, probably the most important rule would be never buy an investment purely because it has been going up in price, and never sell it purely because it has been going down.

I would put the expense ratio first for mutual funds. I would say, I will never consider a fund with expenses over X. And then I would probably factor in portfolio turnover, I would factor in tax efficiency, I would put in a measure of risk, and I would put performance dead last. In fact, I would also have a decision rule that I can't actually look at the performance of the fund at all until I've determined a short list of funds that passed all the other screens. And only then would I look at performance. Because if you look at performance first, it then becomes an unconscious bias, and it will skew your analysis of everything else you look at. So you have to put performance dead last because otherwise it would be first no matter where you happened to think you're ranking it.

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Related book: Your Money and Your Brain