The Unspoken Behavioural Biases that Influence Professional Fund Investors

Although increasingly aware of the concept of behavioural biases; we remain poor at accepting that they directly relate to our own decision making, largely because we struggle with the negative inferences.  Take professional fund investors (a group I consider myself to be part of), we are vulnerable to a host of established biases but many of these are rarely acknowledged or discussed.  What can we infer from behavioural science research about the judgments made by buyers of mutual funds?

– We will favour fund management groups that have provided gifts and hospitality, no matter the price.  Small gestures may even be more influential than those of greater value.

Whilst undoubtedly the most difficult bias to acknowledge, the evidence on reciprocity – our desire or obligation to return a good deed – across all aspects of life is overwhelming, and professional  fund investors are not immune.  The fund industry (certainly in the UK) has sought to restrict the value of gifts and hospitality by asset managers seeking to sell their wares to prospective investors; however, the notion that limiting the monetary value prevents reciprocal behaviour is entirely spurious (see Katz, Caplan and Merx, 2003). Indeed, small gifts can be more influential – individuals provided with lavish gifts and hospitality may not invest in a fund managed by the giver for fear of the perception that their decision has been influenced, but as small gifts and hospitality are considered ‘inconsequential’, they can accept them without any questions raised about impartiality.  It is crucial to highlight here that reciprocity is an ingrained and often unconscious act, in most cases we will be blithely unaware of how our behaviour is being impacted, and indeed we are likely to rail against the very notion that we can be influenced in such a fashion.

– We are inclined toward investing with fund managers / sales people that we like.

Another of Robert Cialdini’s key pillars of influence (in addition to reciprocity) is ‘liking’; that is we are more readily persuaded by people that we like. This might be because they are similar to us, because they offer us compliments: “that was a great meeting, you really understand our fund”, or because we find them physically attractive.

– The further into an in-depth due diligence process we are for a fund; the less likely we are to identify a major problem with the strategy.

Detailed due diligence is crucial for any credible fund selector, but the time and effort of such a process can leaves us vulnerable to sunk costs – after multiple meetings and reams of analysis the prospect of abandoning research can become unpalatable.  More work makes us more committed (Garland 1990).

– The moment we see the performance track record of a fund our assessment of the quality of the philosophy, process and fund manager will change.

The grip of outcome bias is difficult to escape and even harder to see in ourselves.  In Baron and Hershey’s (1988) study on medical decisions and monetary gambles they found consistent evidence that participants rated the quality of a decision as better and the decision maker as more competent when the outcome were favourable rather than unfavourable (all other things being equal).  Given the amount of luck and randomness in the returns delivered by active funds, outcome bias is a particular problem for fund investors.

– We will recognise worrisome process related issues with underperforming fund managers that we would never have ‘identified’ had the performance been strong.

Outcome bias is so important to fund manager selection that I will mention it twice.  A classic case of the issue is evidenced by mutual fund investors propensity to sell losers and run winners (the reverse disposition effect), which is driven, in part, by our assumption that poor outcomes (disappointing performance) must be linked to problems with the process.  Thus, team changes, capacity issues or style drift are often cited as reasons for the sale of an underperforming fund; even if results can better be attributed to the general wax and wane of financial markets.

– We will blame the fund manager for poor performance and accept the credit for outperformance.

That we tend to internalise success and externalise failure has been well-documented in psychological research with a variety of causes, such as the desire to present ourselves in a favourable light or to enhance or confirm our own self-worth (Shepperd, Malone and Sweeny, 2008).  As fund investors we are, in essence, delegating investment decisions to a third party, and the opportunity to succumb to self-serving bias is great; as are the potential problems stemming from it – most notably an inability to learn from mistakes.

– We will erroneously associate strong presentation / public speaking with the possession of fund management skill.

The halo effect is a situation where we take one prominent and strong trait for an individual (or group) and extrapolate our positive view across of all of their characteristics (Nisbett & Wilson, 1977).  There is no proven correlation between communication skills and fund management aptitude, but we can easily become captivated by compelling presenters and discard those lacking the ability to converse in a convincing manner. It is also important to note that there is inevitably a selection bias in the pool of available active fund managers, with confident and persuasive individuals more likely to ascend to the upper echelons of the industry.

Key Reading:

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

Cialdini, R. B., & Cialdini, R. B. (2007). Influence: The psychology of persuasion New York: Collins.

Garland, H. (1990). Throwing good money after bad: The effect of sunk costs on the decision to escalate commitment to an ongoing project. Journal of Applied Psychology75(6), 728.

Katz, D., Caplan, A. L., & Merz, J. F. (2003). All gifts large and small. American Journal of Bioethics3(3), 39-46.

Nisbett, R. E., & Wilson, T. D. (1977). The halo effect: Evidence for unconscious alteration of judgments. Journal of personality and social psychology35(4), 250.

Shepperd, J., Malone, W., & Sweeny, K. (2008). Exploring causes of the self‐serving bias. Social and Personality Psychology Compass2(2), 895-908.

Please note all views expressed in this article are my own and are not necessarily shared by my employer.

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