Behavioural Finance: Applied
The Professional Investor’s Primer
By Shyma Jundi Ph.D., Clare Flynn Levy and Imad Riachi Ph.D.
Whether you’re already acquainted with the principles of behavioural finance, or this is your first exposure to the topic, this white paper provides a practical reference guide to some of the behavioral biases most humans exhibit, but with a focus on those that will resonate with professional investors.
Behavioural Finance – All talk and no application?
The tragic heroine Lolita poignantly observed, ‘I have the feeling that something in my mind is poisoning everything else’. Lolita may have had the insight to become a successful modern day investor, as it turns out. As humans, our minds are constantly and significantly influenced by our emotions. We view profit and loss emotionally – we avoid loss intensively, as we know it will be accompanied by feelings of disappointment and regret. The outcomes of our decisions leave emotional imprints which then affect our future behaviour.
Unfortunately, that future behaviour can be irrational, and, when it comes to money, can have a negative impact on our bottom line. That’s where behavioural finance comes in, to explain how and why investors do not always behave rationally.
Behavioural Finance applies psychology-based theories to investment decisions. It has become a hot topic thanks to factors ranging from the emergence of cognitive sciences as a mainstream subject, to the rise of technology to analyse human behaviour more accurately and seamlessly than ever before. Post hoc assessment of the recent financial crisis shows the telling ways in which biased behaviour played havoc with the market.
But what is the point of all of this talk of Behavioural Finance? Is it purely for theoretical and literary ponderance? Is it a marketing gimmick? Is it is a way to “beat” the market? Or is it merely an excuse to point a finger at other people’s absurdity? To date, there’s been a lot of talk and very little application. Where Behavioural Finance is being applied, the focus is either on “outsmarting the herd” (i.e. building quantitative models focused on predicting market behaviour – technically referred to as Behavioural Investing), or on improving the expectations of, and investment decisions made by, retail investors. Both are worthy pursuits, but it begs the question: What about professional investors and advisers, themselves? Are they immune to behavioural biases? What are they doing to recognise their own biases and adjust for them, to improve their own investment skills?
The purpose of this paper is to discuss just that: how professional investors can apply the principles within and around Behavioural Finance to maximise investment skill and minimise any negative impact of behavioural bias.
What are professional investors and advisers doing to recognise their own biases and adjust for them, to improve their own investment skills?
What Does Behavioural Finance Mean? An introduction to some of our favourite biases
Behavioural Finance applies the cognitive sciences to financial decision making. Whereas much of its study has been focused on models of aggregate market behaviour, understanding why we behave the way we do as individuals requires a broader understanding of the psychology of decision-making and human motivation.
It all starts with the human brain – every human brain, regardless of whether it belongs to someone who is being paid to invest money on behalf of other people, someone who is creating algorithmic trading models, or someone who has little interest or experience in investing at all. Our brains were built to work in cohesion with our bodies, to keep us out of mortal trouble. For most of us, the threat of being eaten by a large animal is no longer a daily concern, but evolution is slow going. The primitive parts of our brains continue to exert strong control over our behaviour, whether or not the circumstances actually warrant it.
Neuroscientists claim that up to 95% of our behaviour is governed by our subconscious (Lipton, 2005). It is our subconscious that leads us to buy products that sit at eye level on the shelf, and that encourages us to respond more readily to a ‘get 1 free with every 3 purchased’ offer than a ‘4 for the price of 3’ offer. In the context of making investment decisions, it leads us to behave in ways that are irrational, but that will sound very familiar to any professional investor.
Neuroscientists claim that up to 95% of our behaviour is governed by our subconscious.
Kahneman (2011) identified Systems 1 and 2, which underlie the way we think. Intuition (or System 1), is fast and automatic, and the reasoning process usually includes emotion. This kind of reasoning is based on formed habits, conditioning and association, and is difficult to change or manipulate. It comes from experience, but it operates subconsciously. Reasoning (or System 2) is slower and much less rigid – it consists of deliberate, conscious judgments and attitudes.
Professional investors sometimes talk about feeling physical symptoms – goosebumps, for example – when their intuition notices an opportunity or issue. That’s System 1 in action, and working to the investor’s advantage. But System 1 can work against us, as well. In the context of Behavioural Finance, expressed as behavioural bias. The study of behavioural biases now forms part of the syllabus in many business schools, but it has yet to form part of the consciousness of many of today’s professional investors.
Countless books and research papers have been written on the topic – some focus on the body itself and the power of hormones, whereas others focus on the mind and/or the emotions. Some list all of the subconscious biases that have been documented to date.
There are five common bias groups to which investors (professional and amateur) fall prey:
- Predicting the Future
- Believing Things That Aren’t Necessarily True
- Fearing Loss
- Being Led by the Ego
- Getting Attached
We explore each of these below.
1. Predicting the Future
Our minds are constantly attempting to predict the future, based on anything and everything we experience. In the case of Projection Bias, our minds assume that our future selves will share our current emotional state. For example, although doing the maths is not actually that difficult, many of us don’t manage to set aside enough money for retirement when we have a good year; somehow we assume that we will always have money. Many finance professionals have been shocked into recognising their past projection bias in wake of the financial crisis – they weren’t expecting multiple years without performance fees or bonuses, or even redundancy without a quick recovery.
Recency Bias is the “overweighting” of recent information. It’s what makes roulette players feel as though recent results form a pattern. In investment, it is demonstrated by the belief that a share price move one day is predictive of how it will move the next day. Of course, if enough people act on recency bias, it may become self-fulfilling, as is the case with momentum-driven markets. But the point is to be aware of it as a potential “real” reason for your own investment decisions.
The Snake Bite Effect:
When we experience a financial loss, recency bias can be expressed as an increase in risk aversion – the Snake Bite Effect. The Snake Bite Effect is what caused many people stop travelling by plane in the wake of 9-11, for example.
In each case, our subconscious mind is using the relatively recent past and extrapolating it into the future in such a way that is at odds with the balance of probabilities.
3. Fearing Loss
People dislike losses on average 2 to 2.5 times as much as they enjoy gains.
Loss Aversion is what leads us to avoid risk when gains are at stake, but seek risk when losses are at stake. A classic example: Which would you rather do: take $100 now, or take a bet where there’s a 50% chance you’ll win $0 and a 50% chance you’ll win $200? Ok, now, which would you rather do: give us $100 from your pocket now, or take a bet where there’s a 50% chance you’ll lose $0 and a 50% chance you’ll lose $200? Loss Aversion is what leads most people to take the £100 in the first scenario and take the bet in the second one. In fact, research has shown that people dislike losses on average 2 to 2.5 times as much as they enjoy gains (Kahneman & Tversky, 1974).
Below: Prospect Theory as applied to gambling gains/losses (Kahneman and Teversky, 1974):
An expression of Loss Aversion, the Disposition Effect is what leads us to run our losing positions too long and cut our winning ones too soon: a very common habit among both professional and amateur investors. Research to measure the Disposition Effect has shown that winners that were sold outperformed losers that were retained by an average excess return of 3.4% per annum (Odean, 1998).
4. Being Led by the Ego
The tendency to over-estimate our own abilities is a common thread across multiple behavioural biases, and is one of the greatest pitfalls for professional investors. Indeed, research has shown that “experts” are generally even more overconfident than everyone else. It doesn’t help that people prefer those who sound confident and are even willing to pay more for and/or excuse bad performance from confident (but inaccurate) advisors (Montier, 2010).
Illusion of Control:
Professional investors often overestimate their ability to control the market, yet they tend to not admit to this belief. Humans have a strong motivation to control their environments, particularly in stressful and competitive situations, and the Illusion of Control has been found to be most likely to occur in specific circumstances: When a lot of choices are available, when you have early success at a task (e.g. you get a few calls right, early in the game), when the task you are undertaking is familiar to you, when there’s a lot of information available, and when you have a personal involvement. In other words, every day in the life of a professional investor, the conditions are highly conducive to the Illusion of Control (Moniter, 2010). Unfortunately, but not surprisingly, professional traders with a propensity toward the Illusion of Control have been found to experience substantially lower performance and earnings (Fenton-O’Creevy et al. (2003, 2005)).
Professional traders with a propensity toward the Illusion of Control have been found to experience substantially lower performance and earnings.
Self-Serving Attribution Bias:
The tendency to attribute good outcomes to skill and bad outcomes to sheer bad luck is called Self-Serving Attribution Bias. So it’s not surprising that the research shows that feedback that emphasizes success rather than failure can increase the Illusion of Control, while feedback that emphasizes failure can decrease or reverse it.
5. Getting Attached
Familiarity Bias (aka Home Bias):
Although better risk/return propositions may reside further afield, many professional investors prefer to stick closer to home. It’s when “only investing in what you understand” is taken too far. For example, more than 60% of the assets in the Enron 401(k) program consisted of Enron stock. When the company collapsed, not only did employees suffer a loss of income, but many also saw their retirement savings wiped out – that was due to their own bias. Enron was an extreme example, due to the share price outcome, but many pension funds ban investment in their own equity in order to avoid just this sort of risk. Another example of Familiarity Bias is the continued tendency for some pension funds to invest heavily in domestic equities, despite the fact that their liabilities are no longer primarily domestic.
Once you own something, the human tendency is to start to place a higher value on it than others would. This Endowment Effect can cause us to hang on to portfolio positions that, if we had a clean sheet of paper, we would not buy at the current level. Those positions may be little 0.2% scraps, but they add up. The most oft cited example of the Endowment Effect is where participants were given a coffee cup and then offered the chance to sell it or trade it. The people who owned coffee cups wanted approximately twice as much money for them than the people without coffee cups were willing to pay for them, even though it had only been minutes since the coffee cups appeared on the scene (Kahneman,Knetsch & Thaler, 1990).
Effort Justification (aka the Ikea Effect):
Related to the Endowment Effect, Effort Justification describes the mind’s tendency to value things that have taken more effort, more highly. If you’ve ever spent hours obtaining and assembling a piece of Ikea furniture then looked on eBay to see how much it’s worth used, you’ll feel this one. Likewise, when you’ve put massive effort into researching a position or assembling a portfolio, it is very easy to lose objectivity.
Sunk Cost Effect:
Likewise, most professionals in any industry will recognise the tendency to continue investing (time, money or energy) into a project based not on its objective merits, but rather the impact of “sunk costs” (the previously invested capital and time now lost). This is what leads us to “throw good money after bad,” when really we should be looking at the decision with a blank piece of paper, and it’s strongly connected to Loss Aversion.
Is the Subconscious Always “Bad”?
One thing that all of the biases we have described (and that list is by no means exhaustive, by the way) appear to have in common is that they are “bad” – they lead us to do irrational things that are detrimental to achieving an optimal outcome. But what about the times that our subconscious leads us to success? Many successful fund managers and traders will say that they rely on intuition much of the time in making investment decisions. Sometimes their intuition has a physical manifestation: George Soros notably felt back pain when his portfolio needed reviewing, others say the hairs on the back of their necks stand up when a particularly profitable opportunity comes along. That intuition is the subconscious talking, and it can be right.
So if the subconscious is sometimes leading us astray, but is also sometimes the secret of our success, how can we use it to our advantage? The key lies in unpicking luck, skill, conscious decisions, subconscious bias and intuition – in other words, understanding not only what decisions you have made, but why.
If all of that sounds like a lot of hard work, rest assured: It is work, but it’s not hard.
Maximising Professional Investor Skill
Professional investors could benefit substantially from treating themselves like
Professional investors are in a privileged position: they hold in their hands millions of people’s livelihoods and they get paid handsomely for it. Those fees may well be justified where true investment skill, and the effort to maximise it, is demonstrated. But how is this achieved?
The first step is identifying where a professional investor’s skill actually lies, the next is to maximise it. In other words, figure out what specifically you’re good at and do more of it; figure out what you’re bad at and do less of that. It’s common sense, really. It’s a question of capturing and analysing data, identifying actionable insights about both conscious decisions and subconscious biases, and then using those insights to change behaviour.
Changing behaviour means creating or adapting your investment process, and instilling discipline in following the process. Confirmation Bias, for example, can be confronted by actively seeking out the opposite point of view and then being completely honest with yourself in deciding whether your analysis overrides it. Discipline means making that a formal part of your investment process.
Unfortunately, when our primitive brains are pushing us to do the opposite, it is hard to stay disciplined about adhering to it. We need tools to facilitate it.
Most of the literature recommends keeping an investment diary as a way to learn from your mistakes (and successes), mitigating both Self-Serving Attribution Bias and Hindsight Bias (Montier, 2010). But if you’ve tried that before, you know that the discipline of doing it with a pen and paper dissolves rapidly. The good news is, technology can simplify the process to the point where we can stick with it.
In professional sport, this process of identifying skill and changing behaviour in pursuit of excellence is commonplace – athletes do not win gold medals without thoroughly understanding what is working and what is holding them back, both physically and psychologically: a feedback loop. They arrive at this understanding by using both technology and coaches, and they treat it as an ongoing process: a quest for continuous improvement.
Professional investors could benefit substantially from treating themselves like professional athletes, yet in actuality very few do. The reality is that they do not have the bandwidth, expertise or resources to do it by themselves. Yet it has the potential to change their lives (not to mention the P&Ls of their companies and their end investors) for the better.
Despite the fact that most of the literature on Behavioural Finance to date has been focused on experiments and academic studies in controlled environments, there’s no doubt that the principles are directly applicable to all investors, whether they be amateur or professional. For professional investors to assume that they are immune to subconscious bias would be a perfect example of one of the most common biases: Overconfidence.
Now for the good news: research (Fenton O’Creevy et al., 2012) has shown that biases such as the Disposition Effect can be mitigated with practice: what is required is a feedback loop to enable the investor to see quickly and accurately what the impact of their actions is. That’s what we do at Essentia.
Essentia provides cloud-based software that makes it easy for professional investors to capture the data they need to create a productive feedback loop, and to take action on the feedback. We train top portfolio manager coaches in how to use the software to maximise the benefit of their services. In a nutshell, we treat professional investors like professional athletes, empowering them in their pursuit of investment excellence.
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