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Open minds and sunk costs

14 December 2016

Russell Harrop - Head of International Equities

I’ve written my wish list for Father Christmas, the length of which seems to be inversely proportional to my age. The item I’m most looking forward to though (assuming, of course I’ve been good enough in 2016 to receive any presents) is Michael Lewis’s latest book: ‘The Undoing Project: A Friendship that Changed Our Minds’.

For those not familiar, he’s the author of influential end-of-the-80’s Wall Street takedown book “Liar’s Poker”. I did read, however, that he’s dismayed (but not actually surprised) to find the book treated as a training manual by some future ‘Masters of the Universe’. He’s also the author of “The Big Short” which showed how, contrary to popular opinion, more than a few people did see the 2008 great financial crisis coming (and made profits off the back of it to make any of the ‘stars’ and devotees of Liar’s Poker green with envy).

His latest book is about two psychologists who have / had (one’s no longer alive) spent their careers looking into human reasoning. Much of their work focuses on the ‘gaps’ in that reasoning and the realisation that the human mind plays just as many tricks on us as our eyes do. Yet, whilst we are aware of optical illusions from a young age, for the most part we live blissfully unaware of these ‘judgement illusions’. This is a problem. For instance, not being aware of our innate attitude to risk causes us both to make decisions without understanding our biases, but also to make ones where the range of potential outcomes simply doesn’t align with subconscious risk tolerance. What's really important to know about is how would you actually feel if your portfolio were to fall 5%, or 10%? It’s one of the reasons we believe finding out clients’ attitude to risk involves ongoing conversations rather than simply ticking a box and moving on.

Emotional ties are extremely important to consider when making decisions, but somewhere on the spectrum between occasionally and often they cause a problem. Sunk costs are a classic example. These are costs that have already happened. Logically the fact we have already spent money on something (assuming it is non-recoverable) shouldn’t affect future decisions at all. The question is ‘what to spend in the future?’ and this shouldn’t be affected by what’s happened in the past. It is a common issue in investing though, where idioms such as “once bitten, twice shy”, “never catch a falling knife” or “wouldn’t touch it with a barge pole” are all common parlance and can also help to prevent mistakes. We’d wholeheartedly agree that if we can’t learn from our mistakes it’s hard to know what we can learn from. However, the danger is when this becomes a dogma. Hard as it is, we try to both learn from our mistakes and keep an open mind. And sunk costs? When they creep up on us, I’d urge you to try and clear your mind of them and approach the next possibility with the newness it deserves. Holding on to bad decisions just logjams better ones from being taken.