There are two types of people when it comes to investing. The Warren Buffet types, they make lot of money by exploiting market irrationalities and by discovering great companies. They have a knack for it. Then there are Rest of us – we have our day jobs but like to invest our money to grow it faster. There is a third type between these two who are actually like us but think themselves like Warren Buffet – but in real they are just suckers so they do not deserve to be talked about. This post is for people like us. Why machines can do better job than us when it comes to investing. The primary reason is that we “think” – and hence get swayed by lot of our behavioral biases in our decision making. Lets get into the details:
1. We are overconfident
In various surveys asking to rate themselves as drivers – or lawyers, doctors or whatever profession they are into – more than two third believe that they are better than average. Obviously, that cannot be true. In the same way, we believe we are better than an average investors. Mind you, the guy who is selling you (or buying from you) is thinking the same. Not just this, we also overestimate our tendency to take risks. Investors believe that they can take more risks, but then succumb to market pressures.
Machines do not think – so they are never overconfident.
2. We have strong aversion to loss
Do you know that the magnitude of unhappiness that we suffer because of 20% loss is way higher than the happiness we enjoy with 20% gain. We find it very difficult to ride through the losses. Why are fixed deposits so popular? Because you do not see your balance going negative. You must be thinking that you can easily live with temporary 20% loss – please see point number 1. We do not know ourselves that well.
Machines do not feel when they lose money.
3. We procrastinate
Do you know when do people start saving for tax? At the last moment when the HR guys ask for tax proofs. We have strong bias for urgency over importance. Saving money is not urgent – nor does it give instant gratification. We leave it to later – which never comes. SIPs have become very popular now, mainly because investors do not have to take any action every time. Try to do a SIP manually for an year; you will miss most of them.
Machines are automated to do certain things at certain times. They cannot procrastinate.
4. We cannot foresee longer duration
We grossly underestimate time value of money. We understand compound interest but find it difficult to imagine the impact over, say 25 years. Similarly we understand what is inflation but it is difficult to imagine how much a loaf of bread will cost us 25 years from now. Well, you can now do the mental math and find it out – but the point is that we do not always do it while taking important decisions about money.
Machines do not need to imagine life after 25 years, they just calculate and tell you.
5. We cannot do mental accounting
Buying or selling investment products need lot of math. You need to account for transaction costs, tax accounting, valuation of the underlying products etc. Even the brightest of the minds fail in accounting for so many factors.
Machines are meant to calculate.
6. We start believing the crowd
This is the reason why people do not invest money when markets are down while come in horde when markets go up. Most of the retail investors do not make money by directly investing in the markets because they buy expensive and sell cheap. Isnt it logical to do the other way round? Yes, but our human mind finds it difficult to go against the crowd.
There are two ways you can deal with these biases – either train your mind to deal with these biases while making your decisions. Or handover to trustworthy machines. One important thing to note here is that you are not actually outsourcing your long term or big decision making to machines here. You are only outsourcing the smaller decisions and execution of these to machines.
You decide your goals and aspirations, but leave it to machines to calculate how to achieve these goals
You decide the amount of money you want to save in long term, but leave it to machines on how to save for it
You decide “what”, let machines decide “how”
Best of both the worlds!