Category Investments

Behavioural bias: Investors ignore it at their peril

31 January 2023 Joseph Pearson and Anton Pietersen at STANLIB

Even with a vast amount of up-to-the-minute data at their fingertips, portfolio managers are, like the rest of us, prone to natural human biases like overconfidence and lazy thinking, which can cloud their judgement in making rational investment decisions. In a professional asset management environment, there have to be systems in place to control these tendencies.

Nobel Laureate Daniel Kahneman has explained the human mind as an alliance of two ‘systems’. The first is the primitive brain designed around survival, which is capable of rapid, effortless assessments but also vulnerable to cognitive bias. The second system is the modern brain, which allows us to grasp abstract concepts and wrestle with complex decisions. Unfortunately, system two is relatively slow, lazy, demands conscious effort and generally checks in with system one before making a decision, so it imports those unconscious biases.

Here are some of the classic biases which can influence the judgement of even the most ‘rational’ investor.

Hindsight bias: We are tempted to believe that we perfectly understand the past and can therefore predict the future. Google’s success looks obvious in hindsight, but it was the product of luck as well as judgement. As Warren Buffet says, in the business world “the rear-view mirror is always clearer than the windshield”.

Loss aversion: Given a choice between a guaranteed loss of R750, or a spin of a wheel giving a 75% chance of losing R1 000 and a 25% chance of losing nothing, people tend to go for the gamble. Loss aversion suggests that people are so reluctant to lock in a loss that they will risk an even bigger loss just to have a chance of escaping intact. To quote Kahneman, “An investment said to have an 80% chance of success sounds far more attractive than one with a 20% chance of failure. The mind can’t easily recognise that they are the same”.

The narrative fallacy: Narratives are an effective way to store information. If you were asked to memorise fifty random numbers, it would be a daunting task. But if you were told that the fifty numbers were the even numbers between zero and 100, it would take no effort at all, since they are described by a system, or narrative. In financial markets, the narrative fallacy emerges in the temptation to extrapolate historic trends into the future and falsely impute a causal link between events. This is particularly dangerous for portfolio managers, whose job is to understand the range of future outcomes.

Overconfidence: As Mark Twain said, “It ain’t what you don’t know that gets you into trouble. It’s what you know for sure that just ain’t so”. Overconfident managers build excessively concentrated portfolios as the benefits of diversification dim along with their sense of their own talent. A strong risk management framework is the only remedy for overconfidence.

Confirmation bias: Confirmation bias is the tendency to emphasise data points that confirm our existing beliefs and ignore those that contradict them. This is a deep bias that can pervade a manager’s investment process. It exacerbates loss aversion and undermines the manager’s ability to accept that events are not playing out in their favour and cut their losses.

To offset these natural human tendencies, we have established a separate dedicated team. The Analytics team, provides advanced analytics and insights to enable investment managers to improve their investment decisions, recognise their cognitive biases and mitigate risks.

If the investment managers are Formula One drivers, the Analytics team is the pit crew alerting the drivers to hazards around the next bend, helping them stay off the gravel and on track, via a simple three-stage process.

• Inform and challenge: The Analytics team produces daily, monthly or quarterly analysis which digs deep into portfolio construction, individual investment decisions and trading patterns to extract insights. They present these insights to the portfolio managers and then play ‘devil’s advocate’, providing alternative or contrarian views to help the managers re-examine their investment process.
• Revisit: Through standardised reporting and consistent communication, the Analytics team maintains an ongoing conversation with the portfolio managers and highlights trends or possible biases emerging in their portfolios.
• Incorporate: The team applies behavioural insights to ensure that our investment process keeps evolving and tries to reduce the size and impact of adverse outcomes. The Analytics team helps portfolio managers to visualise their portfolios’ resilience (or fragility) under various stressful scenarios, such as the Global Financial Crisis of 2008.

The outcome of this process is that portfolio managers construct more resilient portfolios, are better able to manage risk and can achieve better results aligned with their mandates.

Although we live in an era of astonishing computing power, building effective investment portfolios demands human flair and creativity. To be most effective, that creativity has to be linked with the science of analytics to alert investment managers to their innate bias and help them to manage it.

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