Dramatic price falls can be painful for investors, and there has been no shortage of them in 2016. Whether it’s a market sell-off or a single stock disaster, unexpected events cause stress that can lead to bad decision-making. For that reason, pre-planning for a crisis can be a powerful way of making better choices.
Pre-prepared checklists are nothing new in investing. It’s a subject where you often see the names of finance legends like Mohnish Pabrai, Charlie Munger and Michael Mauboussin mentioned time and again. To varying degrees, all of them suggest using checklists as a way of combatting “known unknowns”. Or as Mauboussin puts it:
“When probability plays a large role in outcomes, it makes sense to focus on the process of making decisions rather than the outcome alone.”
Why precommitment works
Pre-committing to a plan can be used everywhere in investing. It can help in sticking to strategy rules and being properly diversified. But it’s when things get difficult that a plan is most important. That’s because our natural instincts can easily turn a bad situation into a catastrophe. The trick is to make a dispassionate plan before the crisis happens.
Take Sir John Templeton as an example. The late, highly respected value investor once famously wrote that:
“The time of maximum pessimism is the best time to buy, and the time of maximum optimism is the best time to sell.”
It was a profitable contrarian strategy for Sir John. But even he needed pre-planned discipline to make sure he acted on it. His deep-value approach meant leaving open ‘buy orders’ with his brokers for perhaps months at a time. Those orders were set at much lower prices where he knew he’d have a wide margin of safety. But he also knew that when the market tumbled to those levels, he’d be as fearful as everyone else. So he placed those orders in advance. Sir John was clearly well aware of what’s known as the empathy gap...
How the empathy gap can ruin good decisions
There are various studies of how, in stressful situations, strong emotions lead people to behave differently to how they expect - otherwise known as an empathy gap.
In one study, researchers tested the theory people gamble more than they plan to when they’re in a casino. Ahead of the visit, the gamblers in the test were fairly conservative in their expectations.…
