Decision-Making Principles in Markets
The quality of our decisions largely dictates the quality of our lives.
Accordingly, it can pay to think deeply and carefully about how we make them.
This article will cover decision-making as it pertains to markets, but we also hope that some of the decision-making principles we cover will also have broader applicability as well.
Key Takeaways – Decision-Making Principles in Markets
- Understand Market Logic – Market behavior reflects economic fundamentals like growth, inflation, discount rates, and risk premiums. Learn the drivers of asset prices and the motivations behind transactions. Analyze how today’s prices incorporate future expectations. Profitable decisions require well-reasoned insights that challenge market assumptions.
- Focus on Expected Value – Think of decisions as having a probability and reward of being right and a probability and penalty of being wrong.
- Gather Quality Information – Prioritize relevant, reliable, and timely data. Complex decisions demand deeper understanding and thorough research.
- Weigh Reversibility – For high-stakes, irreversible decisions, seek more confidence and information. Act swiftly on low-risk, flexible ones.
- Diversify Smartly – Spread trades/investments/returns streams across uncorrelated assets to manage risk and stabilize returns while maximizing the return-to-risk ratio.
Understanding Transactions and Market Behavior
In markets, decision-making is a complex process that involves understanding the multitude of transactions that make up the market.
Each transaction is a simple exchange between a buyer and a seller.
We can better comprehend market behavior by understanding the motivations behind these transactions. This approach allows us to see human nature in action at a very granular level driving markets and economies.
Accepting that markets behave logically is another key concept.
This means recognizing that asset prices are influenced by economic fundamentals such as growth, interest rates, inflation, and risk premiums in predictable ways.
For example, if expected earnings growth is higher than anticipated, stock prices are likely to rise because the future cash flows are now expected to be greater.
Lastly, it’s important to remember that an economy or a market is simply the sum of the transactions that make it up.
If you know the total amount of money and credit spent and the total quantity sold, you know what you need to understand it.
So, when making decisions in markets, try to understand the underlying transactions, accept the logical behavior of markets, and remember that the market is just the sum of its transactions.
Expected Value
When making decisions in markets, it’s important to consider the concept of expected value.
This means understanding that the price of an asset today reflects the collective expectations of future economic conditions.
For instance, if you’re looking at a company’s stock, the current price incorporates what traders and investors think will happen to that company’s earnings in the future.
The stock price will adjust accordingly if those expectations change, say because of a new product launch or a change in the economy.
Similarly, when you buy a bond, you’re essentially lending money for a certain period.
The yield that bond pays is partly to compensate for expected inflation over that time.
If inflation expectations rise, the bond’s yield will increase and its price will fall. Conversely, if inflation expectations decrease, the bond’s price will rise.
So, when making trading/investment decisions, it’s important to have a clear understanding of what you expect the future to look like and how that compares to what the market is currently pricing in.
If your expectations differ significantly from the market’s, that could present an opportunity for profit.
But the market’s expectations are based on the collective wisdom of all its participants – who, on par, are rather sophisticated and it’ll be difficult to sustainably take money away from professionals (i.e., beat a representative index).
So if your views differ, you’ll need strong reasoning to justify why you believe the market is wrong.
In other words, successful trading is about understanding how the future is reflected in today’s prices and then making informed decisions based on that understanding.
Information Needed
When you’re making a decision, the amount of information you need depends on the complexity of the decision and your understanding of the situation.
If you’re buying a cup of coffee, you might just need to know the price and whether you like the taste.
But if you’re investing in a company, you’ll want to know much more.
You’ll want to understand the company’s business model, its competitive position, the quality of its management, and the dynamics of the market it operates in.
You’ll also want to consider broader economic trends and how they might affect the company.
So, the more complex the decision, the more information you’ll need.
But it’s not just about quantity of information. Quality matters too.
You want information that’s relevant, reliable, and timely. And you want to be able to interpret that information correctly.
That’s where understanding how markets and economies work can help. For example, knowing that markets behave logically can help you make sense of seemingly complex phenomena.
So, when making a decision, ask yourself: Do I have enough high-quality information? Do I understand the principles that govern this situation?
If the answer to either question is no, you probably need to gather more information or deepen your understanding before deciding.
Consider the Reversibility of the Decision
When you’re making a decision, it’s important to consider how reversible it is.
Some decisions are like betting all your chips on one hand – if you’re wrong, you lose everything.
Others are more flexible. If they don’t work out, you can easily change course without much of a loss.
In other words, reversibility is about risk. If a decision is irreversible and has high stakes, you want to be really confident before moving forward.
You’ll need lots of information and careful analysis. This is where the idea of weighing the value of additional information against the cost of not deciding comes in.
Sometimes, waiting for more information is worth the delay. Other times, the cost of waiting is too high.
For example, if you’re considering an investment or trade that could make or break your portfolio, you’d probably want to do extensive research and maybe even get a second or multiple opinions.
But if the investment is small and won’t make a big difference either way, maybe it’s okay to move faster with less information.
On the other hand, some decisions are easily reversible.
Say you want to try a new marketing strategy for your business.
If it doesn’t work, you can simply go back to the old one.
In this case, it might be smart to just go ahead and try it, especially if the potential benefit is high.
So, always ask yourself: What happens if I’m wrong? Can I easily fix things?
The answer will guide how much time and resources you put into the decision.
80/20 Rule
The 80/20 Rule, also known as the Pareto Principle, is a concept that states you get 80 percent of the value out of something from 20 percent of the information or effort.
It’s a principle that helps in understanding that not all inputs are equal and that a small number of causes or efforts can lead to a large majority of results.
It’s a useful concept in prioritizing tasks and making decisions, as it helps to identify the key ~20 percent that will yield the most value.
The 80/20 Rule, of course, isn’t a hard and fast rule.
It’s more of a guideline that highlights the imbalance between inputs and outputs.
In some cases, the ratio might be different, such as 70/30 or 90/10 or something else (and can be measured any which way and doesn’t need to add up to 100), but the underlying idea remains the same: a small portion of efforts often leads to the majority of results.
Understanding this can help you focus on what truly matters and allocate your resources more effectively.
Diversifying Among Uncorrelated Returns Streams
Diversifying among uncorrelated return streams is important because it helps manage risk and stabilize returns.
When you have assets/trades/investments/return streams that don’t move in tandem, you’re less likely to experience large swings in your portfolio’s value.
In other words, when one goes down, another might go up or keep performing, balancing things out.
For example, if you have 15 uncorrelated return streams, if one gets entirely knocked out, you know the other 14 are still there if they’re truly uncorrelated.
You take a hit, but a relatively small one.
By spreading your trades/investments across different assets, industries, or geographies that don’t react the same way to market events, you reduce the risk of a big loss.
This approach allows you to achieve more consistent returns over time. It’s like having multiple safety nets; if one fails, others are there to catch you.
Diversifying vs. Riding a Great Opportunity
When it comes to deciding between diversifying and riding a great opportunity, it’s important to remember that no matter how good an opportunity seems, there’s always a risk involved.
That’s why it’s important to emphasize diversification as insurance against the unexpected.
Even if you’re sure about an investment or trade, there’s always a chance you could be wrong. If you put all your eggs in one basket and that bet goes south, you could lose everything.
Let’s say you’ve found a company that looks like a sure thing. It’s growing fast, its financials are strong, and it’s in a promising industry.
You might be tempted to put a lot of your money into that company’s stock. But what if something unexpected happens?
Maybe the company’s main product turns out to have a flaw, or a new competitor enters the market and steals its customers. Suddenly, that sure thing doesn’t look so sure anymore.
Enron was Fortune Magazine’s “Most Innovative Company in America” for 6 straight years with a cult-like following. It nonetheless went bankrupt later in its final year receiving the accolade due to accounting scandals, zeroing shareholders in the process.
This is why we’ve covered approaches like balanced beta, which is designed to perform well under a variety of economic conditions.
For example, if you have investments in both stocks and bonds, when the stock market is down, your bonds can help offset the losses (though it’s no guarantee).
But diversification isn’t just about reducing risk. It’s also about increasing your potential returns.
Being in a variety of assets, you increase your chances of holding the few stocks or other assets that generate exceptional returns.
So, even though you might miss out on some gains from that one great opportunity, you’ll likely make up for it with the overall performance of your diversified portfolio.
And while it can be tempting to ride a great opportunity, it’s usually wiser to diversify.
That way, you can protect yourself from the unexpected and give yourself the best chance of achieving consistent, quality returns.
Example
When you’re looking at two different return streams with varying returns and risks, it’s important to consider both the potential gains and the potential risks.
In this case, assume you have one investment offering 20% returns per year at 10% annualized volatility, and another offering 4% returns per year at the same risk.
Both are uncorrelated, meaning they don’t move in tandem/the fundamental drivers of the return are different.
The key here is to remember that diversification is a powerful concept for reducing risk.
Spreading your across multiple, uncorrelated return streams, you can lower your overall risk while maintaining, or even increasing, your expected returns.
So, while the first return stream might seem more attractive due to its higher return, it also carries a higher risk.
The second, with its lower return and same risk, can help balance out the risk in your portfolio.
In this scenario, you might want to allocate to both, but not equally.
You might consider allocating more to the first investment due to its higher return, but also ensure you have a portion in the second to help lower the risk.
The goal isn’t to chase the highest return, but to achieve the best return per unit of risk.
For example, if you put around 80-85% of your money in the first investment and 15-20% in the second (Modern Portfolio Theory would suggest somewhere around 83/17), you’re not only chasing the higher return, but also protecting yourself from the potential risk.
This way, you’re not over-concentrated, and you’re giving yourself the best chance of achieving consistent, high returns.
So, even though you might miss out on some gains from the first investment, you’ll likely make up for it with the overall performance of your diversified portfolio.
Maximize Your Return-to-Risk Ratio While Keeping It Within Acceptable Risk Parameters
Maximizing your return-to-risk ratio is important because it helps you achieve the best possible returns for the amount of risk you’re taking.
It’s about being smart with your trades or investments, such that you’re not just chasing high returns but doing so in a way that doesn’t expose you to unnecessary risks.
If you can get a higher return without increasing your risk, you’re in a better position.
This is important because the higher the risk, the more volatile (volatility is one definition of risk) your investment can be, which means you could face large losses.
Focusing on the return-to-risk ratio, you’re aiming to get the most out of your portfolio while keeping the downside in check.
For example, if you have two investment options, one with a return-to-risk ratio of 0.3 and another with 0.7, the latter is more attractive because it offers a better return for the same level of risk. This means you can be more confident that your investment will perform well over time.
Keeping things within acceptable risk parameters is about understanding your own risk tolerance and ensuring that your trades or investments align with it.
It’s about not taking on more risk than you’re comfortable with, which can lead to stress and poor decision-making.
In practice, this means diversifying your portfolio to spread out risk.
It also means regularly reviewing your portfolio so that it aligns with your goals and risk tolerance.
By doing this, you can achieve a balance where you’re maximizing your returns while keeping your risk at a level you’re comfortable with.
This approach also provides a more stable and predictable path to achieving your financial goals.
Simplify Wherever Necessary
Get rid of irrelevant details so that the essential things and the relationships between them stand out.
But Don’t Oversimplify
Simplification is important, but it’s equally important not to oversimplify.
Oversimplification can lead to missing important details or nuances that could impact decision-making.
It’s easy to look at a company’s stock price and say “it’s going up, so it’s a good investment.”
But that oversimplifies the situation. You need to look at the company’s fundamentals, its competitive position, the health of the market it’s in, and many other factors.
If you oversimplify, you might make a trade based on insufficient research.
And also factor in how it fits into the broader context of a portfolio.
So, while it’s important to simplify to get to the essence of things, it’s equally important not to throw out the baby with the bathwater.
Keep the important details that inform your decision-making. And remember, it’s not just about simplifying, but about understanding.
Understanding the complex mix of factors that drive markets, drive economies, and drive business success.
Write Down Your Decision-Making Criteria
Writing down your decision-making criteria is a practice that can significantly improve the quality of your decisions.
It allows you to create a sort of decision-making machine, where you think through the criteria you’re using while making decisions and then write them down.
This process helps you handle similar situations in the future more effectively and consistently.
For example, when you make a trading decision, think about the criteria you use.
Systematic traders will convert them into algorithms after sufficient stress testing.
This systemized, evidence-based decision-making approach reduces the impact of emotions, biases, and spontaneous information processing, leading to better outcomes.
By writing down your decision-making criteria, you can also test how they would have worked in the past or in various situations, refining them over time.
Additionally, having a written plan allows everyone involved to see and measure progress against it, so there’s alignment and accountability.
In other words, writing down your decision-making criteria helps you make more informed, objective, and consistent decisions, which can ultimately lead to better results in your personal and professional life.