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How to outsmart human nature and invest rationally

R.B. (Biff) Matthews is chairman of Longview Asset Management Ltd., a Toronto-based investment management firm. Doug McCutcheon is Longview's president.

For the third time in the past 15 years, the Nobel Prize in Economics has gone to a behavioural economist – this year, it was Richard Thaler of the University of Chicago. Clearly, our understanding of human behaviour is evolving rapidly.

Because natural selection happens over millions of years, we are all hard-wired to live in a world that is not the world we live in today. When it comes to investing, the result of such behaviour can be shockingly expensive.

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When investing, our cognitive biases include overvaluing what we own, underestimating the role of randomness, focusing too much on what has happened recently and allowing ourselves to be far more affected by a loss than by a gain of the same amount. We are also overconfident in our ability to predict the future.

Today, we live in an age in which technology can assist us in various walks of life. This raises the question: If human beings consistently fall prey to biases when investing, why not program a computer to invest for optimal results? In fact, this is exactly what a number of investment firms (including Mr. Thaler's firm) are doing, under rubrics such as factor investing and smart beta investing.

Higher returns can be achieved by investing in companies with low valuations and a history of steady growth in earnings.

Investment firms use computers to monitor these factors and automatically adjust their stock portfolios as the factors shift. Studies have concluded that, over the long run, these factors are likely to produce above-average returns.

However, while this is useful for pension funds and other tax-exempt institutions, it is less helpful for individuals who live in an after-tax world. Taxable investors, when exposed to a high-turnover strategy, pay far more in capital-gains tax than necessary.

In addition to the behavioural biases traditionally studied by psychologists, we have noticed that investors find it almost impossible to think about investing and tax planning at the same time – another costly cognitive bias.

How, then, might we devise a system to mitigate our cognitive biases with a view to producing the highest possible after-tax return from stocks over the next, say, 10 years? Even if you don't have the option or desire to use a computer and a complex set of algorithms to invest, here is a basic set of rules that should result, over time, in a superior after-tax result:

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  • Don’t be overdiversified. Twenty to 25 stocks are more than enough to provide sufficient diversification, but not so much that your portfolio starts to mirror the market.
  • Select companies with low levels of debt, a history of steady growth in earnings and a below-average ratio of stock price to earnings per share.
  • For the portion of your capital allocated to stocks, remain fully invested at all times. Recognize that timing the market does not work. What works is time in the market. (Remaining fully invested will be a hard rule for most people to follow, owing to a combination of overconfidence in their ability to predict the future and risk aversion.)
  • Plan to hold your companies for the long run, thereby deferring the realization of capital-gains tax.
  • Sell any stock in a taxable account that has fallen by, say, 20 per cent, in order to trigger the capital loss for tax purposes. If you still think the stock will produce a better-than-average return, buy it back after waiting 31 days (to avoid the tax rules related to superficial losses).
  • If you have both tax-sheltered and taxable accounts, allocate your stocks in order to minimize the tax you pay on dividends, a guaranteed way to increase your after-tax returns. For example, to the extent possible, put Canadian dividend-paying stocks in your tax-free savings account, U.S. dividend-paying stocks in your registered retirement savings plan and non-dividend paying stocks in your taxable account.

If you follow these rules, you will have eliminated many of the most expensive biases that cripple investors. With or without a computer, your long-term after-tax return will be well above average.

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