Five Simple Behavioural Tips for Better Long-Term Investment Decision Making

Although behavioural finance has become an in-vogue topic in recent years and provided many valuable insights into how investors make decisions; it is often fiendishly difficult to put these into practice.  Whilst there are some notable exceptions (such as Save More Tomorrow in the US), much of the work in this field describes what we do, not necessarily what we can do about it. The purpose of this short piece is to highlight five ideas, influenced by behavioural science, which could lead to better long-term investment decisions:

1) Check your portfolio less frequently:  Whilst the benefits of transparency and access are significant they create a range of behavioural problems for the long-term investor.  Quite simply – the more frequently we check our portfolios, the more myopic and risk averse we are likely to become in our decision making. Viewing our portfolios on a daily basis creates an often irresistible urge to react and trade, often at the worst possible times. Although difficult, once we have a sensible investment plan in place, we should try to restrict our observations to a meaningful and realistic level – once a month / once a quarter / once a year.  A gentle nudge for private investors is to set a password for your investment account that is difficult to remember and store that password somewhere it takes a modicum of effort to retrieve. Making something that little bit more difficult, can have a dramatic impact on our behaviour.

2) Don’t make emotional decisions:  How we ‘feel’ at any given point in time can have a material influence on the manner in which we perceive risks and assess opportunities. Making an investment decision in an emotional state – such as excitement or fear – is fraught with problems. If there is any chance that emotion is overwhelming your thinking – postpone the decision. If the idea was a good one, it is still likely to be tomorrow, or next week.

3) Make doing nothing the default:  I vividly recall sitting in an investment meeting at one point in my career and debating what our reaction should be to a particular period of market tumult. Certain participants advocated taking the opportunity to increase risk, others proposed becoming more cautious – both contrasting views were considered by the group to be credible. However, my suggestion of doing nothing was treated with incredulity – something is happening, we must react.   The more we are bombarded with news, information and opinion the greater the temptation to be busy fools and justify our existence as investment managers by taking action, any action.  For a variety of reasons doing nothing is the hardest decision to make for an investor, but it is often the correct one.

4) Choose sensible reference points: Loss aversion is a well-understood concept, but the important role of reference points is probably understated.  We experience losses relative to a particular level, value or benchmark, and what that reference point is can materially impact both how we think about investment performance and the decisions we make.  Unscrupulous investment managers can attempt to exploit this phenomenon by shifting the benchmark, or trying to create a new reference point when reporting to clients: “Whilst your balanced portfolio lost 7% during the period, the NASDAQ Biotechnology index fell by 23%…”  There is no perfect solution here and the decision will be specific to each individual, but choosing a prudent, consistent reference point (or selection of reference points) at the outset of an investment portfolio can mitigate future behavioural pitfalls. An example of a reference point problem would be comparing the performance of your cautious portfolio to a broad equity index in a bull market, experiencing this as a ‘loss’ and deciding to abandon your investment discipline to assume more risk.

5) Write a pre-mortem before making an investment: An idea developed by Gary Klein whereby, prior to embarking on a course of action, you imagine a future state where this action has ended in failure, and then list the reasons why it has gone wrong. This approach can be easily applied prior to making an investment, where you envisage the future failure of the decision and attempt to identify the causes.  It can be particularly useful in a group situation as it gives individuals the freedom to play devil’s advocate.  The technique is effective as it forces us to engage with the prospect of being wrong (which is often unpalatable) and can serve to puncture the overconfidence that can often plague investment decision making.  It is also a useful learning tool as we can retrospectively review what we considered to be the primary risks at the time of making an investment.

The Asset Management Industry Must Confront Biases to Address its Diversity Problem

A recent survey on UK asset managers carried out on behalf of the Diversity Project, highlighted a dispiriting, though not unsurprising, lack of diversity in the industry. Investment management roles are dominated by White men (often privately educated); with significant variation from the broader population composition across a number of categories, including: gender, education, disability and ethnicity.  Whilst these findings would not shock anyone with direct involvement in the field; it is beneficial to have sample data rather than rely on anecdotal evidence.

It would be unfair to claim that the problem is asset management specific, rather than a societal issue; however, this does not exonerate or excuse the industry, which at best reflects the phenomenon and at worst serves to exacerbate it.  The situation is an obvious problem for the groups that suffer from restricted opportunities, but also for the asset management firms that are starved of cognitive diversity.

Although the subject and its consequences are palpable, there is no simple solution.  Many of the behaviours that contribute to the lack of diversity are caused by entrenched biases that are often either unconscious or difficult to acknowledge; a fact that has been evidenced in a range of studies across many years, and a variety of domains.

Bertrand and Mullainathan (2004) carried out a field experiment seeking to analyse the treatment of race in the job hiring process. They sent fictional applications for jobs advertised in Chicago and Boston newspapers, the CVs created were randomly given “African-American or White-sounding names” and the responses monitored. The results of the study were stark:  White-sounding names received 50% more interview requests; furthermore, the difference in response between high and low quality CVs was significant for White-sounding names (close to 30%), but markedly lower for African-American sounding names.  Whether conscious or unconscious, the differential labour market treatment based solely on race evidenced in this study was pronounced.

The issue of gender discrimination was tackled by Goldin and Rouse (2000) through an analysis of the audition process for symphony orchestras. They observed the gender diversity of eight prominent orchestras between the 1950s and 1990s, and sought to isolate the impact of blinding or screening (obscuring the identity of the player), a policy that had been adopted at different junctures by the orchestras under analysis.  The authors found that the use of screening increased by 50% the probability of women progressing from certain preliminary rounds, and accounted for “possibly 25% of the increase in the percentage female in the orchestras from 1970 to 1996” (738, 2000).  These are significant impacts from a simple procedure that obviates the potential for sex-based discrimination.

In a study of racial bias and leadership, Rosette, Phillips and Leonardelli (2008) found that “being White” was considered a typical characteristic for a business leader. The authors suggest that consistent exposure to White individuals in leadership positions and the history of White leaders in business and politics served to perpetuate “being White” as a typical feature or attribute of a business leader.  This view was supported by Gündemir, Homan, de Dreu,, & van Vugt (2014), who displayed that “race neutral” classical leadership traits were more strongly associated with White-majority group members and that “a major cause of the underrepresentation of ethnic minorities in leadership positions in the Western world is that this group does not fit the predominant image or prototype of a leader.” (2014, 1)

Whilst these studies focused on the importance of race as a means of leadership categorisation, we can assume a host of other factors (such as gender, disability, sexuality, social class) are also erroneously (and often unconsciously) used to evaluate an individual’s suitability for a particular role.  It is simple to link this type of thinking to the lack of diversity within the investment management industry – the majority of fund managers share a range of traits (white, male, middle class), which come to be viewed as archetypal, and are interwoven with other features and skills that one might associate with the profession. Thus, a vicious circle is forged where the dominance of a particular group in a role, leads to their aforementioned factors being viewed as characteristic and favourable.

These studies represent only a fragment on the research undertaken on bias and discrimination in the workplace; but serve to provide an insight into ingrained prejudicial behaviour and its potential consequences.  Whilst there is a growing awareness of the issues, there remains a great deal of uncertainty about how to effectively tackle a problem that often seems intractable.

Although businesses are increasingly keen to place diversity at the forefront of their employment practices, such simple signalling is possibly problematic; not only because these declarations do little to address the unconscious nature of many of our biases but, more importantly, it raises the spectre of moral licensing.  First detailed by Monin & Miller in 2001, moral licensing is a situation where “past moral behaviour makes people more likely to do potentially immoral things without worrying about feeling or appearing immoral” (Merrit, Effron and Monin 2010, 344).  As an example, in a study by Effron, Cameron and Monin (2009) participants that expressed support for Barack Obama (shortly prior to the 2008 US election), were more likely to make ‘pro-White’ decisions in an ensuing scenario.  The subjects’ view on Obama provided them with ‘moral credentials’, absolving them of the need to appear non-prejudicial subsequently. Although research on moral licensing is nascent and the subject complex, it is possible that proclamations of diversity are not simply insufficient, but counter-productive.

Given the behavioural hurdles of improving the level of diversity within senior roles in the asset management industry, it is apparent that bold steps need to be taken.  One example, in a different field, is The Rooney Rule in professional American Football (NFL), which requires that one minority candidate is interviewed for all head coaching positions and senior operations jobs.  The rule was designed to address the lack of opportunity for minority coaches in the NFL.  Although there remains much debate about the efficacy and desirability of such an approach, DuBois (2015) estimated that a minority head coach candidate was 19-21% more likely to acquire the role following the imposition of the Rooney Rule.  Furthermore, it has been contended that the Rooney Rule decreased discrimination by reducing “the archaic biases regarding the intellectual ability of minority candidates” (Collins 2007, 870).

In the absence of a counterfactual, it is difficult to precisely assess the impact of the Rooney Rule; however, given the potential strength of our biases it is easy to see how a policy that compels behaviour change from employers and alters the typical candidate pool could serve to both improve short-term opportunities for under-represented groups, whilst eroding harmful stereotypes and biases over the long-term.  For asset managers, an adapted version of this approach could be utilised when hiring for both senior positions and also more junior levels, such as graduate programs.

For each possible ameliorative strategy there will be imperfections and the potential for negative behavioural spillovers (where an intervention backfires and produces the opposite effect of that intended).  However, there is little doubt that the biases that impact recruitment in the asset management industry are deep-rooted and material; for meaningful change, bold thinking and actions are required.

Key Reading:

Blanken, I., van de Ven, N., & Zeelenberg, M. (2015). A meta-analytic review of moral licensing. Personality and Social Psychology Bulletin41(4), 540-558.

DuBois, C. (2015). The Impact of “Soft” Affirmative Action Policies on Minority Hiring in Executive Leadership: The Case of the NFL’s Rooney Rule. American Law and Economics Review18(1), 208-233.

Collins, B. W. (2007). Tackling unconscious bias in hiring practices: The plight of the Rooney rule. NYUL Rev.82, 870.

Claudia, and Cecilia Rouse. (2000). Orchestrating Impartiality: The Impact of “Blind” Auditions on Female Musicians. American Economic Review, 90(4): 715-741.

Effron, D. A., Cameron, J. S., & Monin, B. (2009). Endorsing Obama licenses favoring whites. Journal of experimental social psychology45(3), 590-593.

Gündemir, S., Homan, A. C., de Dreu, C. K., & van Vugt, M. (2014). Think leader, think white? Capturing and weakening an implicit pro-white leadership bias. PloS one9(1), e83915.

Lavergne, M., & Mullainathan, S. (2004). Are Emily and Greg more employable than Lakisha and Jamal? A field experiment on labor market discrimination. The American Economic Review94(4), 991-1013.

Merritt, A. C., Effron, D. A., & Monin, B. (2010). Moral self‐licensing: When being good frees us to be bad. Social and personality psychology compass4(5), 344-357.

Monin, B., & Miller, D. T. (2001). Moral credentials and the expression of prejudice. Journal of personality and social psychology81(1), 33.

Rosette, A. S., Leonardelli, G. J., & Phillips, K. W. (2008). The White standard: racial bias in leader categorization. Journal of Applied Psychology93(4), 758.

The Perils of Past Performance

The role of a fund investor is to identify active managers (individuals or teams) with some form of edge or skill that can deliver excess returns relative to a specific index or hurdle rate.  We seek to uncover a process (application of skill) that delivers a positive outcome (outperformance).  Whilst this may appear to be a simple concept, isolating skill in the field of investment is a complex task, particularly given the undue focus on how well a fund has performed historically – which as a standalone measure provides no indication of skill and can materially skew our (seemingly) objective judgements.

To evidence skill there must be a direct and deliberate link between process and outcomes. If I am playing golf, take aim at the flag and proceed to shank the shot, but the ball ends up in the hole after ricocheting off a tree, that is not skilful – even though the ultimate outcome is both the one I intended and positive.  Furthermore, there must be a large sample to validate skill – a single successful golf shot could be mere fortune, after one hundred attempts the influence of luck is significantly reduced.

The ability to discern skill also depends on the type of activity undertaken – some activities are dominated by randomness, others can be influenced by skill.  Michael Mauboussin (2012) suggested an intuitive test for judging whether something is more subject to luck or skill – is it possible to fail deliberately? Take a lottery – it is impossible to purposely fail when playing; provided the ticket is correctly completed, the probability of success cannot be impacted by the combination of numbers selected, and the result is entirely arbitrary. Contrastingly, chess is a game dominated by skill, with limited influence from chance or randomness; it is easy to intentionally lose a game by recklessly sacrificing key pieces.

We can apply such a framework to active fund management; however, we rapidly arrive at definitional problems.  Even if we assume that outperformance of a benchmark is a robust indicator of a successful outcome – over what time horizon should this apply? For example, an active equity manager could attempt to deliberately fail (or underperform their benchmark) by selecting a range of companies with characteristics contrary to those in which they typically invest; yet if the efficacy of this strategy was assessed over a short time period (one day, for example), the outcomes would be driven by luck – did the market rise or fall on the day? What was the key macro-economic news? If, however, we extend the time period then the impact of random short-term market vacillations should wane and fundamentals exert more influence.

Lengthening time horizons in our assessment of active management certainly improves our ability to distinguish between luck and skill – but it is by no means failsafe. Even over the long-term, a randomly selected portfolio can (and often will) improve upon a market cap allocation (absent fees) and active managers frequently outperform for reasons that are not directly related to their process. Thus, whilst long-term past performance information for a fund is preferred, as a measure of skill it is severely limited.

The problem with historic fund performance is that it is devoid of context and impacted by a blizzard of variables over which the manager has no control. Returning to the golfing analogy – viewing headline fund performance in isolation is akin to judging that I am a skilful golfer by observing on my scorecard that I recorded an eagle, without knowing that I dented a tree.  It is all outcomes and no process.

This presents a challenge for investors; we seek coherent and consistent narratives and want to believe that strong active fund performance is a direct result of skill as this is the simple, coherent explanation.  The world becomes incredibly complicated when a good process delivers a bad outcome, or vice-versa.

The issue of outcome bias – our propensity to judge the quality of a decision or process by its outcome – has been consistently evidenced in behavioural research (See Baron & Hershey, 1998), yet our awareness of the phenomenon seemingly does little to shake its influence. Survivorship bias, return driven ratings and performance screens still suggest an undue focus on historic performance. Whilst the common behaviour of investors selling funds that have struggled after three years and investing in those that have outperformed over the same period is well-documented.

Professional fund investors are aware of this issue, of course, and most have thorough due diligence processes for analysing active investors, which downplay the influence of the historic excess returns delivered by a fund. The problem, however, is that as soon as we are aware of the headline performance / outcomes of a strategy then it will impact our perception of all elements of the approach.  Outcome bias would suggest that our assessment of the quality of two identical strategies would differ markedly if one reported strong historic headline performance and the other weak. Therefore, it is not just that past performance can take undue precedence in our assessment of an active fund manager, but that knowledge of it can influence all other considerations.

This is not to suggest that past performance analysis contains no relevant information, or that it should be ignored entirely; however, where considered it must be framed by the appropriate context, rather than employed as a binary good / bad marker. The primary consideration should be – is the behaviour of the strategy consistent with expectations, given my knowledge of the philosophy and process adopted?  Even then, whilst providing some useful evidence about the historic characteristics of the strategy, assessment of past performance in this more nuanced manner provides minimal guidance on whether a manager possesses skill because it remains difficult to link the outcomes to any underlying process.

Identifying skill in an active fund manager is incredibly difficult – long-time horizons are a pre-requisite and past performance alone does more to mislead us than guide us – but it is not impossible. Crucial to the endeavour is thinking about different types of outcomes; focusing on specific decisions through time, rather than top-level fund performance. This involves understanding the rationale for holdings and positioning within a portfolio and observing their impact – this provides us with a far greater sample from which to judge skill and offers a more direct link between process and outcome (though admittedly not free from noise)

Such a method also allows us to pinpoint areas of skill and locate potential weakness.  There is no skill of ‘active fund management’, rather individuals or teams may possess expertise in certain facets (this could be areas of the market, types of security or particular disciplines, such as portfolio construction); disaggregating decision making and outcomes is a crucial means of understanding where competitive advantages or particular abilities may exist.   Blunt past performance evaluations provide no information on this aspect.

That isolating skill requires us to find evidence linking process to outcomes also highlights the importance of maintaining due diligence once invested in a particular active strategy.  When initially researching a manager much of the questioning will relate to historic decisions, and the manager will be vulnerable to post-hoc rationalisation and hindsight bias, where (consciously or unconsciously) the rationale for historic decisions is prone to revision.  Regular monitoring meetings with active managers offer reams of ‘live’ decision making evidence, which is far less susceptible to the aforementioned problems. This is particularly crucial when invested in a fledgling managers / approaches where the level of confidence that skill exists and will offer persistent advantage must necessarily be limited.

Given that outperformance is the ultimate objective of active fund selection, it is unsurprising that so much attention is lavished upon historic results; yet in a chaotic and unpredictable system focusing on such a context-free number is highly problematic.   Not only does it leave us exposed to mean reversion and conflate skill with luck; it serves to influence our perspective on all other relevant evidence. Although it is impossible to expect investors to research funds without an awareness of its past performance, we should continue to strive to reduce its relevance in any due diligence process and move to a point where investing in a fund with a strong recent track record might be seen as much a problem as it is a validation.

Key reading:

Baron, J., & Hershey, J. C. (1988). Outcome bias in decision evaluation. Journal of personality and social psychology54(4), 569.

Mauboussin, M. J. (2012). The success equation: Untangling skill and luck in business, sports, and investing. Harvard Business Press.

Why is Value Investing So Difficult?

There is a simple heuristic for gauging the investment style adopted by a fund manager; it is based on how you feel when looking at the holdings in their portfolio. If you feel comfortable – they are a quality investor, if you feel excitement – they are a growth investor, and if you recoil in horror – they are a value investor.

Last year, the value investment team at Schroders highlighted a significant investor bias towards growth stocks amongst managers in a certain peer group.  This tendency was not surprising – in the majority of major equity markets growth has trounced value in recent years (2016 being an exception), and through this period many value managers will have lost assets and jobs.  For those managers with more malleable investment philosophies, their portfolios will have inexorably become growth orientated as the style delivered excess returns.

However, what is perhaps even more diverting than these relatively short-term factors is the longer-term dynamic.  The value premium is one of the most robust and consistent phenomena in academic investment research (Fama & French, 1998, Asness, Moskowitz, Pedersen, 2013), yet as an investment style it appears to exist at the periphery.  Despite a considerable weight of evidence to suggest that value outperforms growth over the long-term; it is the latter that seems to dominate the investment landscape – the siren song of barriers to entry, nascent demand, earning upgrades and secular tailwinds is seemingly irresistible.

It is important to clarify what is meant by value – it is a nebulous concept and few fund managers admit to owning expensive stocks.  The traditionally favoured metric is price/book, which has characteristics that are ideal for academic research, but may be too narrow for our purposes. Instead, I will define a value approach as such:

Investment in a stock trading at a discount to the market or peers in relative terms across a range of metrics and / or below its intrinsic value; where there is no expectation for the underlying business to produce operational results (sales growth / margins / earnings growth) in excess of their historic average or the norms for their industry.

Although admittedly convoluted, the crucial point is that value stocks should be observably cheap across a number of metrics and not require abnormal operational results to justify investment.  There is no obligation for a value investor to hold companies that are demonstrably high quality or that possess superior growth prospects; rather they seek companies where the share price unfairly represents the operational realities of the business.

From a behavioural perspective, a value approach is difficult for a fund manager to consistently apply and demanding for a fund investor to hold, and these issues contribute significantly to the paucity of genuine value strategies available, despite the compelling empirical evidence.   There are myriad of behavioural pitfalls that blight value investing, and rather than produce an exhaustive list, I will highlight those I perceive to be the most material:

–  Narratives: We have an overwhelming desire to construct, and believe, coherent, simple narratives. Walter Fisher (1978) first posited the narrative paradigm theory, which argued for the pre-eminence of storytelling in human communication – compelling tales outweigh robust argumentation. Growth stocks often benefit from beguiling narratives, which we inextricably link to positive share price performance, whereas value stocks suffer from the reverse –‘cheap for a reason’ is the common slight aimed at undervalued stocks. As investors strive for consistency, it is hard to reconcile the typically negative narrative that accompanies a depressed value stock with the potential for strong future performance.

– Recency: Even if we define our approach as long-term, we are inevitably biased toward current events and overweight the importance of the recent, compared to history.  This is a major headwind for a value style, as it is often predicated on the reverse – ignoring the short-term noise and focusing on the longer-term attributes of an investment.

Availability: A closely related concept is the availability heuristic (Tversky & Kahneman, 1973), whereby the perceived frequency or probability of an event is driven by what is available – or what easily comes to mind. This create a number of problems for value investors – notably, we are more likely to recall prominent examples of companies that experienced difficulties and failed (so called value traps) rather than those which have undergone problems and staged solid, yet unremarkable, recoveries.  Thus, our bias is likely to be towards overstating the worst case outcome. Furthermore, when assessing an individual company, we are likely to overweight current and readily available information, which is typically negative in regard to value stocks.

– Salience: Griffin & Tversky (1992) argue that we struggle to differentiate between the strength of evidence and its weight – that is the salience of evidence often supersedes its credibility.  Information that is distinctive or prominent will tend to dominate our thinking, and in the case of value stocks the arresting information is likely to unfavourable and therefore prone to exaggeration.

Affect:  A plethora of studies have highlighted that decision making is often driven by how we ‘feel’, rather than cognitive evaluations (including: Lowenstein, Weber, Hsee & Welch, 2001), and value investing is undoubtedly emotionally taxing.  A value investor often has to invest counter to ‘common wisdom’ and the prevailing market narrative for sustained periods. Furthermore, on a significant minority of their investments (if they are skilful) they will be proved wrong and the market negativity justified. Making a mistake when the market ‘knew’ the problems faced by a company and the negative narrative was ‘obvious’ is far more damaging to ego and reputation, than the failure of a consensus growth stock where the positive narrative does not result in robust returns.

Given that there are substantial behavioural impediments to running, or investing in, a value fund, the obvious solution is to employ systematic strategies (active or passive), which not only nullify the problems of human behaviour, but seek to exploit them. Whilst this is certainly a viable route to accessing the value premium, it is likely that there remains an advantage for those select, traditional active fund managers able to filter genuine value opportunities from the aforementioned traps. However, perhaps the sternest question for systematic value strategies is whether fund investors have the fortitude to maintain positions in such approaches for the long-term.  We struggle with owning value stocks with negative narratives, and this challenge is exacerbated when we hold a systematic fund and perceive it to be ‘blindly’ buying into ailing or out of favour companies.  Thus, there are no simple solutions.

Whilst in its basic form a value approach may be considered elementary compared to other investment styles, it is the most exacting behaviourally; this is a key reason why a long-term premium exists for owning value stocks and why both active managers and fund investors struggle to embrace the discipline.

Key Reading:

Asness, C. S., Moskowitz, T. J., & Pedersen, L. H. (2013). Value and momentum everywhere. The Journal of Finance68(3), 929-985.

Fama, E. F., & French, K. R. (1998). Value versus growth: The international evidence. The journal of finance53(6), 1975-1999.

Fisher, W. R. (1978). Toward a logic of good reasons. Quarterly Journal of Speech64(4), 376-384.

Griffin, D., & Tversky, A. (1992). The weighing of evidence and the determinants of confidence. Cognitive psychology24(3), 411-435.

Loewenstein, G. F., Weber, E. U., Hsee, C. K., & Welch, N. (2001). Risk as feelings. Psychological bulletin127(2), 267.

Tversky, A., & Kahneman, D. (1973). Availability: A heuristic for judging frequency and probability. Cognitive psychology5(2), 207-232.

Why Don’t Fund Investors Sell Winners and Hold Losers?

The disposition effect – that is the propensity for investors to relinquish winning positions and maintain losing holdings – is one of the most prominent findings of behavioural finance, and has been widely studied and corroborated (for example – Frazzini 2006, Shefrin & Statman 1985, Weber & Camerer 1998).  However, this description of investor behaviour often seems in sharp contrast to the activity of mutual fund investors, where the leaning appears towards the opposite – abandoning underperforming holdings and persisting with those delivering excess returns. A study by Chang, Solomon and Westerfield (2014), confirms this view and contends that fund investors evidence a reverse disposition effect.  But why does fund investing provoke such a different behavioural response?

First, it is important to understand the existence of classic disposition theory.  Although there are a range of competing explanations, the most compelling is that of cognitive dissonance (Festinger, 1962), which relates to our desire to find uniformity in our beliefs and values; avoiding situations where there are conflicts or inconsistency.   If we make an investment that subsequently falls in value, or underperforms, we face the prospect of cognitive dissonance – we believe we are a skilful and diligent investor, yet the performance of the security jars with this view, creating a significant disconnect. Selling the position and crystallising a loss would only serve to confirm this contradiction, thus our tendency is to maintain the position and hold the opinion that we are right – just not quite yet.

Fund investors are not immune to cognitive dissonance, but they have an alternative means of relieving the stress caused by its occurrence – the ability to delegate accountability.  Faced with the same dichotomy of believing in your own investment abilities, whilst witnessing a poorly performing investment choice, a resolution can be found by placing blame with the underlying fund manager and selling the investment.

This type of delegated investment authority has been referred to as a psychological call option (or indeed a protective put), which is a reasonable analogy – with a fund investment one can claim credit for the upside, whilst capping the (psychological) cost of disappointment.  Outperformance is the result of superior fund selection, underperformance the consequence of problems with the fund manager.

Whilst this behaviour supports the desire for internal consistency, it also serves to protect our ego in the public domain. After diligently researching a fund and then stridently advocating it to your team / peers / clients; witnessing it struggle, even over brief and irrelevant time periods, can be emotionally taxing and perceived as damaging to your reputation.  A decision to sell the fund is therefore far more easily rationalised by believing that things (out of your control) have changed, rather than acknowledging a mistake.

The inclination to sell losing funds is compounded by our bias towards outcomes and desire to construct coherent narratives. A proclivity to judge the quality of a decision or an activity by its results alone, leads us to identify problems with underperforming funds and become complacent about outperformers (despite performance alone providing minimal insight into the quality of an investment approach).

When a fund is underperforming, the urge to develop a persuasive story accounting for the returns is often overwhelming.  Disappointing outcomes ‘must’ be related to some fragility in the investment approach, thus we seek to forge links between process issues (for example, capacity, team changes, style drift) and the performance delivered, even if the connections are erroneous.  These patterns are exacerbated by the preference to expend more time studying struggling funds in order to understand and explain performance.  Carrying out extensive research on a fund only to conclude that the underwhelming return is primarily due to random market noise, is unlikely to prove satisfying, even where accurate.

Confronted with an underperforming fund, an investor has three potential courses of action (this is a simplification):

i)                    Retain confidence in the holding as there has been no marked alteration to the philosophy and process, and the performance is consistent with expectations given the market backdrop. Maintain the fund.

ii)                  Acknowledge that although nothing material has changed, a mistake was made in the recommendation. Sell the fund.

iii)                Identify a problem with the fund stemming from some kind of change or unwanted / unexpected development, which can be linked to performance.  Sell the fund.

The first two options are by far the most behaviourally exacting.  Maintaining confidence in a fund holding despite underperformance falls foul of our strong desire to link outcomes directly to process, and does nothing to relieve the aforementioned cognitive dissonance.  Admitting an error serves only to crystallise the dissonance and tarnishes our ego.  Contrastingly, the third option is behaviourally compelling.  It enables us to relieve our dissonance by allocating responsibility elsewhere and sates our want to consistently align process and outcome. Given these features, the tendency of fund investors to sell losing positions is, perhaps, unsurprising.

This post is not designed to argue that we should blindly hold poorly performing funds, nor that there are never process problems or changes causing poor outcomes, rather it seeks to explain why the behaviour of fund investors appears to contradict the long established disposition effect.  The decision making dynamics of fund selection differ markedly from individual securities, and lead to an apparent reversal of the phenomenon. This should not be viewed as either a positive or negative, simply a distinct behavioural challenge for investors in active funds to address.

Key Reading:

Chang, T. Y., Solomon, D. H., & Westerfield, M. M. (2016). Looking for someone to blame: Delegation, cognitive dissonance, and the disposition effect. The Journal of Finance71(1), 267-302.

Festinger, L. (1962). A theory of cognitive dissonance (Vol. 2). Stanford University Press.

Frazzini, A. (2006). The disposition effect and underreaction to news. The Journal of Finance61(4), 2017-2046.

Shefrin, H., & Statman, M. (1985). The disposition to sell winners too early and ride losers too long: Theory and evidence. The Journal of finance40(3), 777-790.

Weber, M., & Camerer, C. F. (1998). The disposition effect in securities trading: An experimental analysis. Journal of Economic Behavior & Organization33(2), 167-184.

 

Why Do Investors Ignore Certain Risks And What Is A Probability Threshold?

In the classical model of decision making we identify our preferences through systematically valuing each available alternative by multiplying its probability with its ‘utility’.  Such a hyper-rational approach is clearly unrealistic and fails to provide a descriptive account of how we actually behave.  Whilst most of our judgements must, either implicitly or explicitly, combine some assessment of potential outcomes and probabilities, our perception of these is dominated by our behavioural biases.

Of particular interest for this post is our handling of probability. This encompasses both how we ascertain a level of probability for a given occurrence and how we use that probability to inform our decision making.  In most scenarios the choices we make are in a state of uncertainty – meaning that we are never aware of the true probability properties of a given decision; thus our views are highly subjective and context dependent.

A number of anomalies have been identified in our treatment of probability; most prominent is Tverksy and Kahneman’s Cumulative Prospect Theory (1992), which posits that individuals tend to overweight low probability events with extreme outcomes.  This behaviour has been displayed in a number of fields such as lotteries (Clotfelter & Cook, 1990) and horse racing (Snowberg & Wolfers, 2010), where the favourite is ‘underbet’ and the longshot ‘overbet’.

Whilst there is evidence to support an inclination to overweight low probability, extreme events; research on insurance somewhat contradicts this notion.  Kunreuther & Pauly (2004) showed that individuals often failed to protect themselves from the consequences of catastrophic loss, even in situations where the cost is subsidised and the policy is undervalued (Camerer & Kunreuther, 1989).  Thus, in certain circumstances, rather than overstate the probability of an extreme event, there is a tendency to disregard it completely.

McClelland, Schulze and Coursey (1993) studied insurance behaviour in a laboratory setting and found that insurance against low probability risks possessed a bimodal distribution – that is participants were prone to either dismiss or exaggerate the risk presented.  Slovic, Fischoff, Lichtenstien, Corrigan & Combs (1977) reported that individuals were reticent to purchase insurance when the probability fell below some threshold – a threshold that was seemingly specific to each individual.

That there appears to be bimodal treatment of low probabilities, suggests that there is a probability threshold inherent in decision making, wherein the presumed probability of an occurrence must be above a particular level for it to be deemed worthy of consideration.  In the context of disaster insurance, Kunreuther & Pauly (2004) state that individuals need to be sure that the probability of an occurrence is above a threshold level before they even begin to search for detailed information on the value of protection.

The existence of a probability threshold might be considered an effective adaption allowing us to filter ‘noise’, limit worry and focus our attention on areas we deem pertinent. Furthermore, given that it is often difficult to evaluate the probability of an event, a simple ‘relevance heuristic’ that allows us to discard risks seems prudent and efficient.  However, this behaviour is highly problematic – not only is it injudicious to entirely reject certain high consequence risks, our ability to accurately gauge probabilities is severely limited and impacted by a swathe of behavioural biases including availability, recency and salience (we will cover these in more detail in later posts). Thus, we may be ignoring a particular risk that we subjectively perceive to carry a low probability, when in reality the likelihood is significantly greater.

The implications of this phenomenon are important for all investors – encompassing individual stock decisions to macroeconomic postulations – as our ability to understand probabilities and appropriately consider risks to paramount in the evaluations we make.  There is no simple solution to this issue, but there are a number of partial remedies:

–  Give specific probabilities to risks: We should be more willing to ascribe probabilities to risk factors.  This is not with any expectation of our estimation being right, we will almost certainly be wrong; but rather it allows us to be open and explicit about our thinking, and compare it to how our portfolios are positioned.  If we are running scenario analysis we should not simply look at the potential magnitude, but be explicit about the perceived likelihood of such an event. Formally assigning probabilities to risks also allows us to actively engage with our views, track how these evolve and react to new information.

–  Source opinions from across a team: Our perspectives on probabilities are highly subjective and will often vary significantly between individuals, comparing and combining probability expectations may serve to offset or counter some of our individual biases.

–  Take an external view: The caveat to the above is that the cognitive diversity within a team can often be limited.  Obtaining perspectives from people remote from your group, and with no vested interest in giving a particular view, should enhance the breadth of thought.

Such activities are, of course, no panacea; we are poor at forecasting and often risks will arise that were never previously considered, let alone discarded (black swans, unknown unknowns…).  Furthermore, our commitment to our own beliefs are often so resolute as to be unshakeable, thus the impact of the above approaches may be limited. These factors notwithstanding, the existence of a probability threshold and our propensity to ignore risks has profound ramifications for our investment decision making, and even small changes to our behaviour could garner material benefits.

Key reading:

Camerer, C. F., & Kunreuther, H. (1989). Decision processes for low probability events: Policy implications. Journal of Policy Analysis and Management8(4), 565-592.

Clotfelter, C. T., & Cook, P. J. (1990). On the economics of state lotteries. The Journal of Economic Perspectives4(4), 105-119.

Kunreuther, H., & Pauly, M. (2004). Neglecting disaster: Why don’t people insure against large losses?. Journal of Risk and Uncertainty28(1), 5-21.

McClelland, G. H., Schulze, W. D., & Coursey, D. L. (1993). Insurance for low-probability hazards: A bimodal response to unlikely events. In Making Decisions About Liability And Insurance (pp. 95-116). Springer Netherlands.

Slovic, P., Fischhoff, B., Lichtenstein, S., Corrigan, B., & Combs, B. (1977). Preference for insuring against probable small losses: Insurance implications. Journal of Risk and insurance, 237-258.

Snowberg, E., & Wolfers, J. (2010). Explaining the Favorite–Long Shot Bias: Is it Risk-Love or Misperceptions?. Journal of Political Economy118(4), 723-746.

Tversky, A., & Kahneman, D. (1992). Advances in prospect theory: Cumulative representation of uncertainty. Journal of Risk and uncertainty5(4), 297-323.

 

 

 

Does Control and Transparency Increase the Behaviour Gap?

A behaviour gap can be defined as a divergence between an individual’s actions and what may be considered a rational or optimal path.  In the field of investment, such a discrepancy is often highlighted by detailing the differential between time weighted and money weighted returns; with the latter being impacted by the timing and magnitude of investor cash flows.  Both Morningstar and DALBAR have produced research attempting to calculate the tangible investment cost of our behaviour.

Whilst it is impossible to precisely attribute disappointing investor results to a particular set of behaviours, there is certainly sufficient evidence to suggest that investment outcomes are persistently and materially impacted by our cognitive and emotional biases.  This post will focus specifically on the influence of myopic loss aversion and consider how this phenomenon may be exacerbated by developments in the investment industry.

The existence of myopic loss aversion was first posited by Benartzi and Thaler (1995) in their explanation of the equity risk premium.  The idea combines the concept of prospect theory with the propensity of individuals to make short-term / high frequency observations.  Kahneman and Tversky’s work on prospect theory has been heavily popularised, thus I will not cover this in detail, but rather reiterate the relevant aspect  – that individuals are loss averse (relative to a reference point) and a loss weighs more heavily than an equivalent gain. Thus, our behaviour will tend to direct us away from situations involving losses.

The short-termism of myopic loss aversion is a form of mental accounting wherein gains and losses are appraised over brief time horizons, even if the overarching investment objective is long-term.  The influence of observation frequency was further evidenced in a study by Thaler, Tversky, Kahneman and Schwartz (1997) where, in a hypothetical portfolio management task, participants in the group receiving monthly performance feedback (relative to yearly or five yearly) finished the five year period with the most risk averse portfolio allocations.

The study of myopic loss aversion was furthered by Hardin and Looney (2012), and their review of the relevant literature found three vital variables impacting myopia:

Information Horizons:  The timespan over which prospective returns and risk are presented is an important factor influencing behaviour.  There has been evidence from a number of studies that extending the information horizon leads to a greater appetite for risk taking due to the broader framing.   For example, the potential for recording an absolute loss in an equity fund is greater over a three-month horizon, than a five year horizon (other things being equal), thus our timeframe is central to how we perceive losses.

Evaluation Frequency: How often an investor reviews investment outcomes is also crucial to decision making.  The more readily we monitor performance, the more risk averse we are likely to be.  This is an intuitive concept – higher risk investments are more likely to generate negative returns over short time periods and the more frequently we interact with return information, the greater the opportunity for myopic loss aversion to exert an influence.

Decision Frequency:  The type of investment decisions we make can also be materially impacted by how often we make decisions.  Restricting investment decision making tends to reduce risk aversion, as investors are less likely to encounter, and therefore trade on, short-term losses.

The literature suggests that behaviour consistent with myopic loss aversion is stimulated by focusing on short-term performance information (historically and prospectively), regularly reviewing investment outcomes and making frequent investment decisions.  In isolation, or combination, these factors can promote risk aversion, lead to conservative investment choices and, potentially, substandard long-term returns.  This could be through either cautious initial portfolio allocations or the reduction of risk during periods of short-term stress (or loss).

The impact of myopic loss aversion may also be observable in the preponderance of low tracking error, ‘quasi active’ mutual funds available.  Whilst there are a range of factors that may discourage investors from owning distinctive, high active share funds (despite the evidence supporting such approaches), it is possible that myopic loss aversion is a central driver.   High conviction, differentiated strategies are likely to deliver greater short-term performance variability and periods of relative loss.  Indeed, such approaches are somewhat trapped in a vicious circle where higher levels of relative risk result in meticulous monitoring by investors, potentially promoting behaviour consistent with myopic loss aversion.

The challenge that all investors have to confront is that our vulnerability to myopic loss aversion has increased due to a number of industry developments (particularly technological), which mean that our ability to monitor and control investments has improved markedly.  This visibility and flexibility, coupled with incessant emotional and informational stimulus, makes it increasingly difficult to make, and persist with, prudent long-term investment decisions.

That is not to suggest that increased transparency and control for investors are negative developments – they are an undoubted positive.  It is, however, crucial that as the investment landscape evolves, we are cognisant of the behavioural implications. If not, then any benefits accrued may be offset by the behavioural costs.

Key Reading:

Benartzi, S., & Thaler, R. H. (1995). Myopic loss aversion and the equity premium puzzle. The quarterly journal of Economics110(1), 73-92.

Gneezy, U., & Potters, J. (1997). An experiment on risk taking and evaluation periods. The Quarterly Journal of Economics112(2), 631-645.

Hardin, A. M., & Looney, C. A. (2012). Myopic loss aversion: Demystifying the key factors influencing decision problem framing. Organizational Behavior and Human Decision Processes117(2), 311-331.

Thaler, R. H., Tversky, A., Kahneman, D., & Schwartz, A. (1997). The effect of myopia and loss aversion on risk taking: An experimental test. The Quarterly Journal of Economics112(2), 647-661.