Decisions in investing are influenced by various factors such as age, risk tolerance, portfolio weight, and psychological aspects like equanimity and self-awareness. Daniel Kahneman’s work in behavioral finance highlights how human biases can affect our decisions, often leading to suboptimal choices.
A systematic, rule-based approach can address many of these issues by relying on transparent, fundamental rules rather than emotional reactions. For instance, rules like investing only in companies with a debt-to-equity ratio below 0.5 or a consistent ROE above 15% help maintain discipline and focus on quality. This reduces the impact of cognitive biases and emotional decisions. Best part is we don’t need to reply on subjectivity to create such rules. We can validate effectiveness of rules by analyzing across markets / cycles.
Even Warren Buffett is not immune to emotional decisions, as seen when he bought more shares of Berkshire Hathaway out of anger. By sticking to predefined rules, we can minimize such impulsive actions and improve long-term performance. Ultimately, a rule-based approach helps in making more objective decisions, leading to greater satisfaction with our investing outcomes.
Also, the sheer width of opportunities expands using a rule-based approach.
For more detailed rules and examples, check out this thread on investment rules where we discuss best investment-rules in India tested across market cycles over the last 25 years.
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