The 10 habits of highly effective investors: Part 3

You calculate the expected value of the investment by summing all the parts (30% of 8,000, plus 30% of 7,500 and so forth). Interestingly, the expected value is 7,150, only about 2% above the current level of 7,000. Although the investor was somewhat bullish, when they included a range of outcomes including losses, the expected value was only a modest gain. This shows that using probability can help to reduce "bullish bias" — the tendency to be overconfident about how an investment could perform.

The point is not to look for precise numbers. These are estimates, reflecting uncertain market conditions. The point is to get used to forming estimates and being aware of the range of outcomes. Even for the most promising investment, the range of possible outcomes is not just how much it can go up; it can always go down.

How do you estimate these probabilities? There's no quick answer; it comes with experience. If you've never used probability in investing before, start with a simple approach: what are the odds of the investment going up, staying the same or going down? Set a price target and percentage chance for each outcome. As you gain more experience, you can think about more than three outcomes but these are good enough to get started.

Apply psychology

The second habit of Framing is to apply psychology. We've included a summary of behavioural biases that affect investors, which we invite you to review in this note.¹

For example, you consider buying an ETF tracking a high-growth industry. You're interested because performance has been strong over the last three months. This is an example of recency bias — a cognitive bias where you overweight recent events or performance.

Or say you've been holding a losing stock for a while. Your friend asks if you'd buy the stock today if you didn't already own it — and you admit you wouldn't. But because you already own the stock, somehow you feel attached to it and want to hold for longer, perhaps until you get back to breakeven. This is an example of the endowment effect — an emotional bias where you value something you own more than something you don't own.

Humans are strongly affected by these cognitive and emotional biases. Pausing to consider these biases before investing can help you make better decisions.

Apply history

The third habit of Framing is to apply history. While probability and psychology can take you a long way as an investor, sometimes you'll come across situations you simply haven't seen in your investing lifetime. This is where history comes in, to give you a broader perspective on situations you haven't personally experienced.

Say you wonder if inflation could head higher, well above the 3% upper band of the Bank of Canada's target range. If you've been investing for the last 10 or even 20 years, you likely have very little experience of what this level of inflation looks like and how it affects investment decisions. History might suggest you look both to the 1970s — high inflation with relatively low stock market returns — and the 1980s — still relatively high inflation but with much higher stock market returns. Even this quick journey shows that high inflation, well above 3%, does not always hold back the stock market.

One of the benefits of applying history is that it can improve your judgement. Future market conditions typically don't repeat the exact patterns of the past — history doesn't repeat but it rhymes. This can help you think more deeply, in this example how the current outlook for inflation might be similar or different to the conditions of the 1970s or 1980s.

Improving is the last of the habits — and it consists of applying the other habits. The way to do this is deceptively simple. As you make an investment decision, get into the habit of applying the habits we've discussed, like a checklist:

Governing

• Have a plan: Does this investment align with my plan?
• Think risk: Have I properly considered the risks of this investment?
• Think portfolio: Does this investment make sense in terms of my portfolio?

Knowing

• Get facts: Have I got the facts my grandma would need to make this investment?
• Seek opinions: Have I sought out different views on this investment?
• Test your thinking: Have I outlined my thinking about this investment, including what I would do in a variety of different scenarios?

Framing

• Apply probability: Have I applied probability to this decision, estimating a range of potential outcomes and a likelihood for each outcome?
• Apply psychology: Have I applied psychology to this decision, taking account of cognitive and emotional biases that could affect me?
• Apply history: Have I applied history to this decision, thinking about how the current situation might be similar or different to other situations in the past?

To improve the quality of your investment decisions, you don't need to become an expert in risk management or take a college course in probability. Simply use this final habit — the habit of using the other habits. Individually, each of these habits is relatively simple. Together, they build on each other to create a powerful process. This is a deeper meaning of compound returns, where your knowledge and experience compound over time.

Say you make an average of 10 investment decisions each year.2 Over the course of five years, that's 50 investment decisions. Over the course of 10 years, that's 100 investment decisions. Learn and improve as you go, by applying these habits as you make decisions. The only part you need to do upfront is to have an investment plan, which can be as brief as 1 to 2 pages in point form. That plan could be the most important thing you do as an investor.

We've made this guide about being a highly effective investor, not about being Warren Buffett or beating the market for 10 years straight. If you use these habits consistently, you give yourself a good chance of being a highly effective investor — meaning highly effective in achieving your own goals, on your own terms. At the end of the day, that's what self-directed investing is about.

This concludes our series. We invite you to review part 1 on Governing and part 2 on Knowing, to explore all 10 habits of highly effective investors.

The 10 habits of highly effective investors: Part 1

The 10 habits of highly effective investors: Part 2

¹ Below are behavioural biases that affect investors, broadly categorized into cognitive biases and emotional biases. Source: "Behavioural Biases of Investors" (CFA Institute, 2020).

Cognitive biases

Cognitive biases stem from errors in thinking, memory or information processing.

Overconfidence bias

Overestimating one’s knowledge or abilities.

Confirmation bias

Seeking information that confirms existing beliefs.

Anchoring bias

Relying too heavily on the first piece of information encountered.

Recency bias

Overweighting recent events or performance.

Familiarity bias

Preferring investments that are familiar.

Availability bias

Basing decisions on information that is most readily available.

Emotional biases

Emotional biases arise from feelings, impulses, or intuition rather than deliberate thought.

Loss aversion

Feeling losses more acutely than gains.

Herding behavior

Following the crowd or majority.

Endowment effect

Valuing owned assets more than equivalent non-owned assets.

Status quo

Preferring things to stay the same rather than change.

² The number of investment decisions you make is not the same as the number of trades you place. For example, you might buy 10 stocks in one sector based on a strategy of low relative valuation and high earnings quality. This is arguably one decision, not 10.