How to make the best investment decisions

How do you make the best investment decisions?

It starts with self-awareness. As legendary value investor Benjamin Graham put it, the investor's worst enemy is usually himself. Our decisions are shaped not just by emotion and behavioural bias, but by physiology too — and stress, overconfidence and even hormone levels can push us into taking risks we'd normally avoid.

In this video, Dr Ed Roberts explains the findings of a University of Cambridge study into how cortisol and testosterone affect risk-taking among investors. You'll learn why raised hormone levels make people more optimistic (and more reckless), why this matters when choosing active fund managers, and why the state of mind you're in when you decide can matter as much as the decision itself.

The takeaway: to make better investment decisions, you need to be in the right frame of mind. Avoid big portfolio calls when you're stressed or overconfident, and remember that a rational, unemotional adviser can help keep your decisions grounded.

Chapters / Key points

• Why self-awareness is the key attribute of a successful investor
• Benjamin Graham on the investor's worst enemy
• The Cambridge study: how cortisol and testosterone affect risk-taking
• Why overconfidence doesn't bring higher returns
• What this means for choosing active fund managers
• Why the right frame of mind (and a good adviser) matters

Transcript

How to make the best investment decisions

RP: Hello there. A key attribute for a successful investor is self-awareness. As the famous value investor Benjamin Graham once said: "The investor's chief problem — and even his worst enemy — is likely to be himself."

The issue is partly emotional. Investors are prone to several behavioural biases which hinder rather than help them. But it's also physiological. A study has found that stressful situations, and raised hormone levels in particular, can make people take more risks.

Researchers invited 142 volunteers, all of them students from the University of Cambridge, to play a stock market game, during which their hormone levels were measured. Male participants with higher levels of cortisol were more likely to take risks. Raised testosterone levels had an even bigger effect.

Dr Ed Roberts: It increased risk-taking in riskier stocks, but it also was associated with the participants being more optimistic about the way these stocks would increase in price, so they just thought these stocks would go up more than when they were on the placebo. So it means that they were taking more risks because they were more optimistic about the future. Which is quite interesting, because testosterone might be changing your perceptions of the future, so although the information is the same, you think "No, I think things will be better in the future," therefore it's logical to take more risks.

RP: This research has important implications for investors. If you use active fund managers, remember that they work in highly pressurised and competitive situations. Most tend to be male and many of them are relatively young. So they're likely to have higher testosterone levels anyway. Bear in mind, that could result in them taking more risk than you're comfortable with.

Also, you yourself should avoid making big decisions regarding your portfolio when you're feeling under pressure.

ER: The critical thing is to be aware that these factors do have an effect, so stress has an effect on your decision making, and testosterone would, so in terms of being overconfident, these are factors that do change your behaviour and they don't, on the basis of our experiment, bring you any more returns. So that's sort of the critical thing: if you want to make the best financial decisions, you want to be in the right frame of mind to make those, and being stressed or highly overconfident, irrationally exuberant, those aren't the best conditions for that.

RP: Remember, too, that having a rational and unemotional adviser can also help. Investment decisions are very important. A good adviser will always ensure that the client is in the right frame of mind to be making them.