You’d think from our two articles on fast and slow thinking “5 ways fast thinking is hurting your ETF investments”  and “5 more biases that are hurting your ETF investments” that we were dead set against fast thinking. The truth is, fast thinking is required if we want to take advantage of a rapidly changing global world and is a key aspect of our core-satellite approach to constructing ETF portfolios. This article explains the core-satellite approach to investing and discusses how to make sure your ETF portfolio benefits from the best aspects of fast thinking while avoiding its destructive biases.

Thinking Fast and Slow for investors: A 30-second recap

Daniel Kahneman’s book Thinking Fast and Slow describes the two decision-making modes humans use. Fast thinking is intuitive, emotional, automatic and uses mental shortcuts to achieve optimum decision-making speed. Slow thinking is logical, conscious, systematic and takes focus and effort. 

Investors prefer to use fast thinking even when rational, data-driven thinking would be best (such as when we’re making financial decisions), which inevitably compromises the quality of our decisions. Kahneman’s work has helped investors and their financial advisors better understand the biases and stereotypes that go hand-in-hand with fast thinking, so we can be aware of their power and take steps to ensure slow thinking wins.

The good side of fast thinking

Fast thinking leads us to jump to conclusions, overestimate our own abilities and look for evidence to confirm what we already believe, among other problems. But for all its flaws, there must be some advantages to fast thinking or it wouldn’t have become our go-to way of processing information and making decisions. 

An obvious benefit of fast thinking is its speed. Being able to process information quickly allows us to take advantage of fleeting opportunities and avoid disastrous perils. Previous experience, current context and biology all come together to help us quickly take action. In contrast, the deliberation, research and fact-checking required of slow thinking would mean the moment would pass us by or, at worst, kill us.

It’s easy to see how fast thinking gave humans an evolutionary advantage way back in the day. Similarly, today’s world—particularly when we’re talking about microeconomic forces and their impact on financial markets—demands us to be increasingly nimble, adaptive and agile. 

Is there a way to use fast thinking in our investment strategies so we can take advantage of short-term opportunities without introducing bias and error? We say yes—and it’s the quantitative, core-satellite approach to investing that we use at Adaptive ETF.

Computer-aided modelling is key

In order to make fast investment decisions without introducing bias, we need a quantitative strategy, aided by a computer model. The computer model that underlies the Adaptive ETF strategy has been developed using the best aspects of slow thinking. It’s rational, numbers-focused, factual, well-researched, disciplined and evidence-based. 

Like all good models, ours has been validated using a “back test,” which evaluates the model’s performance against past financial markets to confirm that the theory the model is based on actually works. Then the wisdom and experience of our portfolio management team is used to determine whether those factors that made the model work in the past still apply to the future. If change is needed, the team uses structured, logical and evidence-based thinking—slow thinking—to determine how the model needs to adapt. 

Because the model was built on slow thinking principles, it is immune to the biases that plague fast thinking, including crowd effect, overconfidence bias and loss aversion. But because the model is computer-aided, it processes information and provides recommendations fast, allowing us to make changes to portfolios quickly.

Fast thinking and the core-satellite approach to investing

Speed and agility are particularly important to a core-satellite investment strategy. 

In a core-satellite strategy, we create a portfolio made up of a “strategic core” of broadly diversified ETFs that are typically held for more than a year and a “tactical satellite” of ETFs that have higher risk-return characteristics and are held for a shorter period of time. 

In order to take advantage of short-term opportunities and guard against undue risk, we need to be able to quickly make changes to our ETF holdings, particularly those in the satellite component of the portfolio. 

Thanks to our proprietary technology, we’re able to rank risk and model performance by country, index, sector and commodity. We can assess factors such as global capital flow, currency fluctuation, inflation, seasonal impacts, market returns relative to historic norms, market cycle maturity, and characteristics of the yield curve. And then we can use that data to make fast decisions about how to allocate assets within the portfolio without worrying that we’re introducing bias into our decision-making.

In summary, fast thinking isn’t all bad. In fact, it’s a necessity in a rapidly-changing world. By combining a quantitative model with a core-satellite portfolio strategy, you’ve got the best of slow and fast thinking working to maximize your returns and minimize your risks. 

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Disclaimer

Confidential and proprietary information. The contents hereof may not be reproduced or disseminated without the express written permission of Bellwether Investment Management Inc. (“Bellwether”). Bellwether is registered as: an investment fund manager in Ontario and Quebec; a portfolio manager in Manitoba and Saskatchewan; and as a portfolio manager and exempt market dealer in Ontario, British Columbia, Alberta, Quebec, New Brunswick, Nova Scotia and Prince Edward Island.
These materials do not purport to be exhaustive and although the particulars contained herein were obtained from sources Bellwether believes are reliable, Bellwether does not guarantee their accuracy or completeness. The contents hereof does not constitute an offer to sell or a solicitation of interest to purchase any securities or investment advisory services in any jurisdiction in which such offer or solicitation is not authorized.

Forward-Looking Information. The contents hereof may contain “forward-looking information” within the meaning of the Securities Act (Ontario) and equivalent legislation in other provinces and territories. Because such forward-looking information involves risks and uncertainties, actual performance results may differ materially from any expectations, projections or predictions made or implicated in such forward-looking information. Prospective investors are therefore cautioned not to place undue reliance on such forward-looking statements. In addition, in considering any prior performance information contained herein, prospective investors should bear in mind that past results are not necessarily indicative of future results, and there can be no assurance that results comparable to those discussed herein will be achieved. The contents hereof speaks as of the date hereof and neither Bellwether nor any affiliate or representative thereof assumes any obligation to provide subsequent revisions or updates to any historical or forward-looking information contained herein to reflect the occurrence of events and/or changes in circumstances after the date hereof.

General information regarding returns. Performance is expressed in CAD unless otherwise indicated, gross of applicable management fees. Indicated returns of one year or more are annualized. Past performance is not indicative of future performance.

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