Defining Investing: The Study of Human Decision-Making

What is investing?

This is a subtler question than you might imagine, one that should not be dismissed lightly. Many finance professionals find it to be one of the more challenging problems they encounter.

Over the years, I have refined my own definition to this:

Investing is the art of using imperfect information to make probabilistic assessments about an inherently unknowable future.

Take apart my definition and you learn there is a lot of nuance packed into those 17 words.

• “Art” refers to the fact that this is not a science, and there is no single optimal solution for everybody.
• “Imperfect information” refers to the fact that the information we have is dynamic, incomplete, often confusing, and frequently wrong. No one can know all there is to know at any given moment.
• “Probabilistic” recognizes there are many possible outcomes; investors need to plan not just for the ones they hope for but other contingencies as well.
• “Inherently unknowable” is a humble acknowledgment of how little we know about the future. Most of the time, we do not—and cannot—know what comes next. This should be reflected in how we manage risk and allocate capital.
• “Future” demands optimism. Pessimists have been on the losing side of the trade for all of human history. Setbacks like the dotcom implosion, the GFC and the Covid-19 pandemic were temporary. Pessimism is a bet against human ingenuity, and for half a million years, that has been a losing wager.

Rather than define investing as the science of generating a return on capital, I prefer to consider our behavior when we interact with money; how financial desire impacts our decision-making abilities; what risks we embrace, how we think about wealth, and what emotional pain we willingly suffer in order to generate a return on capital.

Every study of behavior looks at how we solve problems. If this entire endeavor is a problem-solving exercise, then for us to become better investors, we must learn how to make better decisions.

I have learned that the skills needed to be a better investor—to be “less stupid”—are similar to the skills and judgment we need to make better decisions in so many other areas. This affects every aspect of your life—who your spouse is, how successful your career will be, your healthcare outcomes, even how fulfilling your relationships are. Good decision-making leads to increased happiness, greater life satisfaction, and perhaps even becoming the best person you can be.

Too much woo? I am not suggesting that you have to be a great investor in order to have a good life; rather, I want you to think about the skill sets that go into investing and how transferable they are to so much of what you do outside of the world of money.

The more you contemplate it, the more you realize investing is a massive problem-solving exercise. The best at it are intellectually flexible; they approach their craft as a discipline, and focus on process. They understand probability theory and view mistakes as learning opportunities. They use mental models and engage in second-order thinking; they use counterfactuals; they have good information hygiene. They possess a high level of self-awareness regarding their own psychological states. They know they have blind spots and are aware they don’t know what they don’t know.

The process by which you make decisions is worth examining. Whether we are thinking about important milestones in life or our asset allocation, we cannot let our decision-making run on its default setting.

Our definition of investing depends on recognizing what we do and don’t know about the future. We want to make better decisions that will withstand whatever might occur. To do that, we need to ask ourselves what we believe and why. That is what we do next.