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By Jeremy Glaser and Heather Brilliant, CFA | 08-29-2012 02:30 PM

Systematic Approach Can Blunt Behavioral Biases

Articulating your investing philosophy and then sticking with it can help investors avoid the mistakes that often arise with ad-hoc investing in the next big thing, says Morningstar's Heather Brilliant.

Jeremy Glaser: For Morningstar, I'm Jeremy Glaser.

Behavioral finance has been a hot topic over the last couple of years with scores of books and lectures describing how investors are often their worst enemies.

I am here with the director of global credit and equity research Heather Brilliant to get her take on the subject. Heather thanks for joining me.

Heather Brilliant: Thanks for having me, Jeremy.

Glaser: So, can you talk to us a little bit about exactly what behavioral finance is and what a lot of these professors and scholars have been studying recently?

Brilliant: Sure. So there’s been a lot of discussion around the types of traps that investors are likely to fall into based on behavioral biases or things that exist that really cause people to make decisions that would be perceived as irrational, given a straight economic analysis.

It's very clear from hearing a lot of these people give presentations or reading their books, etc., that there are a lot of consistent themes throughout them all. If you ask me, it sounds very obvious when you hear about it, but the hard thing is, I think, for investors to really know, what can I do to combat these behavioral biases or problems that exist in the market.

Glaser: Certainly, these things that are ingrained are difficult to really shake. But what are some of the big takeaways, what can people really do to try to overcome some of these biases?

Brilliant: I think the number one thing is to be systematic as much as possible. So, come up with what you think your personal investing philosophy is. Do you really care about buying companies that have moats, and that’s what you always want to be part of your investing decision? Or is valuation your primary criteria? How do you stack these things up to come up with the best ideas that you’d feel comfortable with? And then implement that systematically.

I think most people, they hear a good idea, they want to look into it a little, and it is a little bit more ad hoc than I think people would generally recommend. Daniel Kahneman has been a big proponent of this. He has been on the speaking circuit talking about this lately, and I think being systematic is something he is a big proponent of.

Glaser: So if you have yourself on the system, though, how do you keep track of everything? How do you really make sure that you are measuring your successes and that you are actually succeeding for the reasons that you think you are, and the same thing with your failures?

Brilliant: A lot of people keep track of their portfolio really well, and then they can see, did I do well in this stock, do poorly in this other stock? But not very many people actually keep track of the reasons why they made the investment decision and whether it worked out for those reasons that they articulated to themselves at the time.

So I think it’s really important to [do this]. Most portfolio trackers have a note function or something where you can even just jot down a few works like, "I think interest rates are going to go up, and that’s why I'm buying Schwab," or "I think natural gas prices are going to go up, and that's why I'm buying Ultra Petroleum," or something like that. So that you understanding the underlying rationale for your investment decision.

Then, when it comes time to measuring your performance, don't just look at how you did numerically, but also look at the rationale behind why those stocks performed or didn't perform. There are some cases, for example, we’ve been making a call on Ford for quite some time. We feel like the trend towards buying more new cars is something that we expect to continue for a while, and we have been right about that. But frankly, the stock hasn't done anything as the multiples contracted.

So that's a case where I'd say we've been right about the stock call, and we’ve had all the right reasons, but it hasn't even resulted in outperformance, and so that's I think another angle to keep track of to really understand your own investing prowess.

Glaser: How much of these suggestions need to be tailored for the individual? Is it one of these things that if everyone gets on a system, they are going to be fine? How much of it needs to tweaked for your personal biases?

Brilliant: Well, when you are looking at some of the research around behavioral economics, there are certainly different aspects that I think different people fall into. So, there are some things like overconfidence that virtually every investor suffers from, but then there are other aspects of investing that I think some people are more prone to than others.

So I think, knowing yourself and knowing, are you someone who really, really suffers from loss aversion, and you’ll do anything to not lose money in the stock? That’s something that you should keep particular care to avoid, versus maybe you are not overconfident, maybe you are actually more worried about all your investments all the time, and you are too quick to pull the trigger and sell. So you can kind of know what your own biases are, as opposed to just focusing on the generalization of biases that are out there in the behavioral theory.

Glaser: So keeping that system, keeping good track of why you are buying things, and really knowing yourself sound like three relatively easy ways to try to overcome some of these behavioral finance traps.

Brilliant: Yes.

Glaser: Thanks for talking to me today, Heather.

Brilliant: Thanks for having me, Jeremy.

Glaser: For Morningstar, I'm Jeremy Glaser.

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