Making good decisions is a key attribute of successful investors and there are ways to improve your decision-making, Phil Moffitt says.
Making good decisions is an important part of investing, but often it is seen as an innate talent rather than something that can be learned.
Phil Moffitt, a Board Director of Aware Super and a former Partner at Goldman Sachs, believes decision-making is a skill and there are techniques to improve this skill.
Good decision-making has a lot to do with people’s ability to engage system 2 thinking, Moffitt says.
The idea that people have two systems of thinking was developed by psychologist and Nobel Prize winner Daniel Kahneman and he describes this in great detail in his 2011 book, ‘Thinking, Fast and Slow’.
System 1 is fast and intuitive; it operates with little effort. Decisions made under this system are often based on patterns and experiences. System 2 is the opposite of system 1 in the sense that it concerns slow, well-thought-out and deliberate decisions.
This type of thinking is ideal for complex problem-solving and analytical tasks, but is not always engaged in by investors when needed. Moffitt believes the reason for this is stress.
My thesis is that stress is inherent in nearly every decision. The more routine a decision becomes the less stress is associated with it. What am I going to have for lunch? I'm not going to get too stressed about that
“My thesis is that stress is inherent in nearly every decision. The more routine a decision becomes, the less stress is associated with it. What am I going to have for lunch? I’m not going to get too stressed about that,” he says in an interview with [i3] Insights.
But investment decisions are often about complex situations, which heightens stress, especially when something unexpected happens.
“It is the stress that prompts people to make decisions quickly because that eliminates that source of anxiety that’s associated with the decision. And so they tend to rely on system 1 thinking, intuitive responses,” Moffitt says.
“But you increase your likelihood of making a good decision if you find a way to engage system 2.”
He says quantitative models are essentially a form of forced system 2 thinking. They are well-researched, well-thought-out models that combine the best of experience and academia so an investor doesn’t rely on snap decisions.
“I reckon it is a formal way of insulating yourself from system 1 thinking because you put all your thinking, your system 2 thinking, into the model. So the model is not independent of your decision-making or thoughts, it’s just that you program system 2, so that when system 1 wants to kick in, you don’t get seduced by it,” Moffitt says.
Two Teams
Moffitt has had a 35-year career as a fund manager and spent 20 years at Goldman Sachs, retiring as a partner at the company in 2019. During his time as an investor he found that not all investment decisions are of the same type.
He found two main categories of decisions: the first deals with the initial decision to invest in a certain asset or instrument and the research behind it, while the second deals with decisions about the ongoing risk management of a position and the assessment of whether an investment still makes sense.
Moffitt found people rarely were good at both.
“When you’re managing a multidimensional portfolio, the combination of assets in the portfolio don’t have a linear relationship with each other – particularly in fixed income, where the relationship between yield and price is non-linear,” he says.
“In equities, the price goes up, or it goes down, but in fixed income the way prices change in the instrument and then between instruments can vary depending on the change in yield. It’s a complex system to be making decisions about.
“I discovered, as I became responsible for people and had to manage investing teams, that some people had the capacity to make these complex decisions at a higher frequency of success. They were just better at it.
“But once the decision is made, it’s not finished. The portfolio continues to evolve and as things change, the assets within it change. What you thought was going to happen doesn’t play out and that requires a secondary decision.
It was clear to me that some people were quite good at identifying an idea and executing, but they were really poor at managing [the position]... And then there are others, who weren't so good or quick at making the initial decision, but actually were very effective in managing the risk once it was established
“But the people who were really good at identifying errors, or successes, and adapting the portfolio to those, weren’t necessarily the same people as those who made the best initial analytical decisions.
“It was clear to me that some people were quite good at identifying an idea and executing, but they were really poor at managing [the position]. And so the overall outcome was not good, even when the initial decision actually was pretty good.
“And then there are others, who weren’t so good or quick at making the initial decision, but actually were very effective in managing the risk once it was established.”
During his time with Goldman Sachs, he experimented with splitting out the two categories of decision-making and appointed different teams to each category in order to get the best results. But he is modest about the success of this model, as they didn’t have the tools to objectively measure the results.
It wasn’t an academic experiment, he argues.
“We didn’t know how to formally measure that, or how to set up an experiment for that, how to control, or how to figure out whether it was significant or not. It was just an intriguing idea that was never properly researched,” he says.
But it did prompt Moffitt to do his own research into behavioural science and he started reading the likes of Kahneman and Amos Tversky. “I realised that I’d spent my career, basically, living behavioural finance,” he says.
Establishing a Process
Moffitt ended up studying psychology with a focus on behavioural finance decision-making at the University of Sydney and completed his degree in 2018. He now runs a consultancy firm, Green Road Consulting, helping businesses with decision-making science.
He is convinced good decision-making can be learned, but often there is no formal process in place to teach it. In many organisations, particularly in financial institutions, the teaching is somewhat haphazard and often takes the form of an apprenticeship.
Young recruits are teamed up with older, experienced investors and they learn through doing. But Moffitt believes there are techniques people can use to improve their decision-making skills more deliberately and reduce the stress associated with the fear of making mistakes.
“You might have an innate capacity to be better or worse at it, but decision-making is a skill. It’s a muscle and you only get good at it if you practice,” he says.
“No one teaches you decision-making, but actually it’s one of the most important things you should learn as you grow up. You want to understand your process and your vulnerabilities.
“The best way to do that is to keep a record of what you did, why and how you felt. And then also how you responded. If you do that, then you might start to spot some patterns. And if you can spot the patterns, then you can manage the patterns.”
You might have an innate capacity to be better or worse at it, but decision making is a skill. It's a muscle and you only get good at it if you practice
Keeping a diary of the thoughts and reasons why you made a particular investment can be helpful in this case. Moffitt points out your notes don’t have to be exhaustive, but a few bullet points on what you decided, why you decided it and what did you expect to happen can go a long way. In a way, it is similar to the five Ws of journalism: where, when, what, why and who.
Moffitt later implemented this model when he had to manage investment teams at Goldman Sachs. “It is about asking yourself: ‘Is something happening that you didn’t think was possible? And when you’re in that space, what are you going to do about it?’” he says.
“We also instituted a routine, where if something was going wrong for somebody, before they transacted they had to speak to somebody. It didn’t have to be the boss, just somebody.”
It helped with reflecting on what happened and why.
Today, it is becoming more common for investment teams to do post-mortems on decisions that turned out to be unsuccessful. But when Moffitt was investing for Goldman, these exercises were unheard of.
“I met somebody who had been involved in aviation safety and they’re incredibly rigorous in examining mistakes. But my experience in financial markets was that if you made a mistake or something went wrong, you made a decision about what to do about it and then you just kind of moved on. There wasn’t really much of a post-mortem,” he says.
“Whereas in the airline industry, there’s an incredibly rigorous post-mortem of every time something doesn’t go according to plan. And that has resulted in much better management of bad decisions.”
Another important ingredient to good decision-making is anticipating obstacles along the way and not only finding solutions to those problems, but getting comfortable with the uncertainty that comes along with it.
“Get used to decisions not panning out the way you expect and think about how you’re going to manage that and the uncertainty and the anxiety that produces,” Moffitt says.
“And with hindsight, all those [processes] helped, it helped a lot.”
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[i3] Insights is the official educational bulletin of the Investment Innovation Institute [i3]. It covers major trends and innovations in institutional investing, providing independent and thought-provoking content about pension funds, insurance companies and sovereign wealth funds across the globe.