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Are You Cut Out For DIY Investing?
The benefits of Do It Yourself are unquestionable; the process is convenient, simple, and efficient. The various stages of the investing experience are usually stitched together seamlessly, often eliminating the need for physical papers altogether
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The rise of FinTech has spawned a new way of investing – “DIY” or Do It Yourself. The DIY method of investing all but eliminates the need for a human investment adviser, choosing to rely on risk-scoring questionnaires and algorithms to churn out customized investment recommendations instead. The customer’s investment journey is subsequently managed using well developed processes and systems that create the perception of a high level of engagement between the platform and the customer.
The benefits of DIY are unquestionable; the process is convenient, simple, and efficient. The various stages of the investing experience are usually stitched together seamlessly, often eliminating the need for physical papers altogether. The recommendations, ironically, are more likely to be in the interest of the client – sans the nearly inevitable colouring that arises from the vested interest of the “human” advisor (business targets, month end sales pressure or higher revenues that could result in higher personal profit, to name a few).
All the plus points of DIY investing notwithstanding, I believe that it could potentially lead to disastrous outcomes for some, but not all, investors. The important question is: how suited is the DIY style of investing to your temperament? Fortunately, a simple test (coming up later) will suffice to nudge you in the right direction.
But before the test, let’s spend a moment understanding how decisions are made. Our “default” mode of decision making is to use emotions rather than logic. All information that we are exposed to necessarily flows through our “emotional brains” first, resulting in what many term as a “gut call”. Needless to say, our emotional decision making processes will be heavily influenced by aspects such as similarity and familiarity, implying that they will be coloured by our past mental conditioning and previous life experiences. Presented with a decision-making framework, the emotional brain first attempts to find a “ballpark” solution to a problem in a quick and dirty manner.
The other aspect of your brain is the “logical brain”, which attempts to stitch together facts systematically and arrive at a given conclusion. Research in Neuroscience has indicated that the logical brain evolved significantly later than the emotional brain; hence the reliance on the emotional brain is far higher for most. Making matters worse, is the fact that most people make spot decisions based on emotions, only to recruit the logical brain to justify the decisions already made thus!
By now, you’ve probably already guessed what I’m getting at. When it comes to making investment decisions, behavioural biases (fired by the emotional brain) can lead you down a path that involves much misery, disillusionment, and financial strife. Almost all long-term investing success is contingent upon your ability to override your initial gut-call and expose it to the litmus test of a well thought out, logical process. Quite unsurprisingly, few can.
If you’re the kind of person who relies more on your emotional brain that your logical one, you’ll be doing yourself a favour by shying away from DIY and seeking the support and guidance of a trusted, conflict-free “human” advisor instead. Convenience and simplicity notwithstanding, pureplay DIY platforms will not have the wherewithal to save you from yourself and your innate tendency to make emotional decisions when markets go awry!
Now, coming back to the test. Fortunately, there’s a rather simple, three question one developed by Shane Frederick of Yale University (called the “Cognitive Reflection test” or CRT) that has been proven to be extremely effective in measuring how well you can put your logical brain to use while making investment decisions. Here goes:
1. A bat and a ball cost $1.10 in total. The bat costs $1.00 more than the ball. How much does the ball cost? _____ cents
2. If it takes 5 machines 5 minutes to make 5 widgets, how long would it take 100 machines to make 100 widgets? _____ minutes
3. In a lake, there is a patch of lily pads. Every day, the patch doubles in size. If it takes 48 days for the patch to cover the entire lake, how long would it take for the patch to cover half of the lake? _____ days
Did you try to solve them? Here are the correct answers (they might surprise you):
1. 5 cents (not 10): by solving the equation X + (X + 1) = 1.1, where X is the price of the ball
2. 5 minutes (not 100): because we have 100 machines working in tandem
3. 47 days (not 24): because the patch doubles in size daily, it doubled on the last day, implying that the lake was half-covered just a day prior
If you didn’t fare too well, don’t fret. In a survey of 3,500 relatively intelligent and well-educated people, Frederick discovered that 33 per cent of respondents didn’t get a single answer correct, whereas only 17 per cent managed to get all the answers right!
If you managed to respond to at least two of the answers correctly, you probably have it in you to go down the DIY way. If you’re part of the 33 per cent who couldn’t ace even one, you’ll be doing yourself a great favour by seeking out the services of a seasoned investment counsellor who has survived through the rough and tumble of at least two market cycles. The last thing you’d want is to have the steering wheel of your investments in your own hands while your emotional brain propels you to zigzag in all directions!