Investment Risk is a Behavioural Phenomenon Not Just a Number

Risk, particularly in finance and investment, is often framed in cold and calculating terms, but such an approach can often lead us to neglect its very human features.  More than simply an absence of certainty*; risk is about our inability to deal with probabilities in a consistent and coherent fashion, and the discomfort caused by the fact that “more things can happen than will happen”**.  How we perceive and experience risk is uniquely personal but at the same time hostage to our common behavioural limitations.

Central to our relationship with risk is how we are feeling at any given time. There is even a formal hypothesis for the role of emotion (or affect) in decision making called ‘Risk as Feelings’, in which George Loewenstein and colleagues argue that emotional reactions often dominate behaviour leading to our decisions diverging markedly anything that might be considered objective or rational[i].  How we feel about something tends to have an overwhelming impact on how we view the probabilities and potential outcomes.  An excellent example of this is psychologist Gerd Gigerenzer’s notion of ‘dread risk’, which he defines as a fear of low probability high consequence events.  Gigerenzer claims that a reluctance to fly following the terrorist attack in New York on September 11th 2001 meant that more Americans lost their lives on the road due to their desire to avoid flying in the following three months than died as a direct result of the horrific attacks[ii].

Whilst dread risk suggests that we often hugely overstate certain low probability, high impact risks, there are other activities where individuals seem to ignore them entirely – for example, driving under the influence of alcohol.  This apparent contradiction is a prime example of the inconsistency of human behaviour.  When it comes to risk, the crucial issues are salience and availability. In Gigerenzer’s example, the emotional impact of the terrorist attacks were both severe and prominent in our thinking, thus the force of the potential outcome engulfed any rational assessment of probability.  Contrastingly, as we start the engine of our car and begin to drive home whilst intoxicated by alcohol are we likely to have any highly emotive examples of the potentially disastrous consequences readily in our mind?

This contradictory treatment of risk has also been evident when observing individual decision making in insurance.  Research has found that people are often underinsured against catastrophe risk – such as floods or earthquakes – even in situations where policies ae subsidized[iii].  Unsurprisingly, the likelihood that you will protect our home from disaster risk is not driven by a rational cognitive assessment of the potential costs, but by how fearful we are of the consequences, or how easily we can recall a similar situation – its availability.  If something hasn’t occurred for a long time or hasn’t recently stirred our emotions, we might simply disregard the risk entirely[iv].  The implications for investors of this type of behaviour are stark.

Salient, emotive and recent events can overwhelm our perception of risk and the investment decisions we make. It leads us to become complacent during prolonged equity bull markets and fearful in the midst of a bear market.  We can think of this as our erratic perception of risk continually shifting our personal discount rates.

Risk is perhaps the second most commonly used term in financial markets (second only to return). Despite its ubiquity and undoubted importance, it is often not clear what is actually being discussed.  The central debate about risk tends to be around whether it refers to volatility (how variable the price of an investment is) or the permanent loss of capital.  Quantitative strategies often rely on volatility as the central measure of risk for an asset or strategy, whereas more fundamentally driven investors will often claim that risk is the chance of losing money.  Both sides of this argument are right that their preferred measure is related to risk, but wrong to believe that there is any single concept that can encapsulate investment risk.

Let’s assume that we have two portfolios – one of 50 medium sized companies all listed on the stock market and one otherwise identical portfolio of 50 companies, but this time the companies are not listed – therefore their valuations are appraised rather than derived from public trading. Furthermore, the public portfolio can be traded on a daily basis, whereas the private portfolio is locked up for five years.  In essence we are contrasting one public equity portfolio and one private equity portfolio.  If we assume that the underlying positions are indistinguishable does this mean that the portfolios carry the same level of risk?

From a fundamental standpoint the answer must be yes – the overall outcomes will be driven by the underlying performance of the companies, but from a behavioural standpoint this is not the case.  The listed portfolio will suffer far greater price fluctuations than the private portfolio and offers the investor the ability to react to these variations (they can buy and sell); by contrast, the private equity portfolio will report smoother prices for the underlying securities, and the investor will be unable to trade – the less observable price fluctuations the less opportunity for us to react emotionally to them.  The behavioural risk (that we make bad decisions) is significantly greater in the public equity option than the private equity option.  This is by no means a validation of private equity structures, rather an example of how risk is about far more than the underlying characteristics of any asset.

Whilst the role of emotion and behavioural bias makes all types of decision making difficult there is an extra problem when we consider our investments.  Many important life decisions are discrete and made at a single point in time – whilst we will be subject to the behavioural  problems when buying a house, once we have made that decision it is not easy to reverse course – we don’t have to make the same decision over and over again.  For investments the opposite is true – once we make an initial investment decision the flexibility to change course means that we are forced to repeatedly face the same choices, but whilst the fundamental decision might be the same – our biases and emotions are likely to frequently alter how we perceive the risk in the decision.

Financial markets also lure us into being excessively diverted by what we might call ‘secondary risks’ or those that are subordinate to our primary objective.  For example, whilst our primary risk for our investments may be a failure to build a portfolio sufficient to maintain our standard of living throughout retirement, there will be a multitude of secondary risks such as suffering from short-term losses or our portfolio underperforming relative to peers or benchmarks.   We often make decisions to manage or mitigate these secondary risks, even if they jeopardise achieving our primary objective.  It’s not simply that we are thinking about risk in the wrong way, but we are thinking about the wrong risks entirely.

We continually discuss risk solely as it pertains to a particular asset or portfolio as if it is remote from the individual experiencing it – this constitutes a glaring omission.  Risk is about our individual differences, how frequently we check our portfolios, how we are incentivised, the last thing we saw on the news, recent stock market performance and how readily we can recall similar emotive examples – to name just a handful of contributory aspects.  Combining the freedom to trade at any time with our fluid view of risk is a potentially toxic cocktail.  Whilst attempting to manage and control such myriad of factors is a huge challenge for all investors, it is one which should not be ignored.

* There is a theoretical distinction between risk and uncertainty, but they can be considered synonymous for the purposes of this post.

**This is an Elroy Dimson quote.


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

[ii] Gigerenzer, G. (2004). Dread risk, September 11, and fatal traffic accidents. Psychological science15(4), 286-287.

[iii] Kunreuther, H. (1984). Causes of underinsurance against natural disasters. Geneva Papers on Risk and Insurance, 206-220.

[iv] Kunreuther, H., & Pauly, M. (2015). Insurance decision-making for rare events: the role of emotions (No. w20886). National Bureau of Economic Research.


The Cricket World Cup, Outcome Bias and Outrageous Fortune (Or How A Wicked Deflection Can Change Everything)

Given how unfathomable the game of cricket is for the uninitiated (and initiated) I am at pains to reference such a wonderfully convoluted activity; however, sometimes sport offers up such vivid examples of our behavioural biases in action that it proves irresistible subject matter. This was the case on Sunday when England won the Cricket World Cup for the first time.  Rest assured this post is more about our behavioural absurdities, than it is about cricket.

Before Sunday, the Cricket World Cup had been held 11 times beginning in 1975 and running every four years (approximately).  Despite being one of the pre-eminent teams, England had never won the tournament, but had finished runners-up on three occasions.  The 2015 World Cup saw a particularly dispiriting and ignominious exit for the England team, which brought about an overhaul of their approach to the game and an ambitious four-year plan to win the trophy when the competition returned to home shores in 2019.

England did indeed win the 2019 Cricket World Cup after overcoming New Zealand in Sunday’s final, but it is unlikely that this would have happened were it not for an outrageous slice of good fortune.  Without going into any unnecessary detail – very late in the game a ball took a wicked deflection off an England batsman after being thrown by a New Zealand player, which resulted in England being gifted extra runs through nothing but sheer chance. Absent this incident England would probably not have lifted the trophy.  Whilst all sport is to an extent defined by luck and randomness, it is worth highlighting that every ex-professional cricketer I have heard discuss this incident has said that they have never seen such a thing happen before. For it to transpire in such a pivotal match at such an important stage of the game is delightfully ridiculous.

It is not fair to say that England were lucky to win the World Cup – there was a great deal of skill that got them to the position to win the competition at all – rather they would have been unlikely to do so without the assistance of an unprecedented freak occurrence.

Following England’s victory, the immediate and persuasive narrative around England’s victory has been:

  • The meticulous four-year plan to transform the game was an incredible success.
  • The team fully justified their pre-tournament favourites tag.
  • The players were able to handle the pressure of a World Cup final.
  • The team proved their ability to win on a difficult pitch*.

These points all have a level of validity, but England probably only won the game because of a once-in-a-lifetime piece of luck – what if everything had been the same, but that outrageous deflection had not occurred? What would the prevailing narrative had been then?

  • England’s four-year plan failed as they lose yet another final.
  • The team didn’t live up to their billing as pre-tournament favourites.
  • They didn’t cope with the pressure of a World Cup Final.
  • The team can only win on ‘easy’ pitches.

The bounce of a ball not only changed the result of a cricket tournament and the lives of the England players, it transformed our perception of everything that led to that victory.  Clearly this is an absurd situation, the assessment of a detailed four-year plan cannot hinge on the random deflection of a ball; but this is the very nature of outcome bias – we take the result and then work back, viewing everything through the lens of that outcome.  Taking such an approach in activities where there is luck and randomness involved is hopelessly flawed.  We seem to operate with a binary narrative switch, which will flick between two entirely contradictory rationales depending on the result.

In my experience outcome bias is one of our most intractable failings, trying to persuade anybody to look past the result and consider the quality of the process underpinning it is nigh on impossible – you often look foolish even suggesting it.  Once the result is in, the narrative is fixed.

So why does the Cricket World Cup matter to investors?  Most sports are dominated by skill but punctuated with doses of luck – in many cases outcomes are actually a reasonable proxy for the quality of a process; for investment the reverse is true – it is luck and randomness with a smattering of skill.  This means we should be even more leery of outcomes alone telling us anything meaningful, but if anything, we are more reliant – performance frames and overwhelms virtually all investment activity and decision making. We are obsessed by the name on the trophy, and care far too little about how it got there.

*Sorry, this is jargon and unnecessary detail.  Certain cricket pitches are harder to bat on and England were accused earlier in the tournament of being only suited to playing on easier pitches.

What Will Investors Be Saying in Ten Years’ Time?

Despite it being most investors’ favourite pastime, we are terrible at forecasting; what we are much better at is talking about events that have happened as if they were inevitable.  If a certain path has been taken it is difficult for us to believe that any other routes were ever feasible or even available.  Whilst this creeping determinism or hindsight bias seems somewhat harmless, it is a damaging trait, which perpetuates outcome bias and leads us to believe that any past decisions made that were contrary to what actually occurred were foolhardy.  Diversification rarely looks sensible after the event – why didn’t you just own the best performing assets?

Having said that it is a serious issue for investors, I will now lurch toward frivolity.  If we go forward ten years, which outcomes will we be claiming were obvious ten years prior?  Some of the hypothetical comments below are more credible than others – I will let you decide which:

–  ‘Value investing was so depressed and had underperformed for the best part of a decade – a recovery was inevitable’

–  ‘US equities were the most richly valued major equity market by some distance, they were due a period of low returns and relative underperformance’

– ‘ The expected returns from a traditional 60/40 portfolio became so low it was simple common sense to increase exposure to alternative strategies, including hedge funds’

– ‘The US tech giants were expensive and facing severe regulatory scrutiny – their time in the sun ended a decade ago.”

– ‘With yields so low it is amazing that investors still held so much duration in their portfolios’

– ‘The vast flows into passive strategies were always going to highlight the flaws in cap-weighted indices, particularly in fixed income markets’

– ‘The Japanification of all major developed market economies was inescapable’

– ‘The return of inflation in major developed market economies was inescapable’

– ‘The long awaited stock pickers’ market finally arrived!’

Of course, we will actually be saying a host of different things – because the investment world is simply too complex, random and reflexive for us to make predictions with any level of confidence.  Taking this into account by making prudent and humble investment decisions now, will mean that some of these choices may seem illogical to our future self – but that is a price worth paying.

The Placebo Effect in Investment

The placebo effect is both fascinating and real, with compelling evidence of its impact in both a medical and marketing context.  Whilst it is in these areas that discussion around placebos tends to focus; the notion that something can make us feel better, even if there is no logical reason for it do so, seems relevant to much investment activity.

The definition of the ‘placebo effect’ from Google is as follows:

“A beneficial effect produced by a placebo drug or treatment, which cannot be attributed to the properties of the placebo itself, and must therefore be due to the patient’s belief in that treatment”.

We can reframe this slightly and create an ‘investment placebo’:

“A beneficial effect felt by an investor by a certain investment activity, which is unlikely to be attributed to the properties of the action itself, and must therefore be due the investor’s belief in that activity”.

What kind of activities might be captured by the above definition (not a definitive list):

– Short-term trading / market timing.

– Trading on macro-economic news.

– Performance chasing in active mutual funds.

The idea of an investment placebo is somewhat distinct from that which is widely discussed in medicine[i] or marketing[ii] – the activity or treatment undertaken in investment is not designed to be inert, rather on average such activities are likely to have a negligible or, indeed, negative impact.  Furthermore, placebos in other areas can actually deliver positive end outcomes – patients can experience improved health following such treatments and consumers get greater enjoyment from drinking a more expensive wine.  In investments, these ineffective activities do not assist in us meeting our end objectives, but simply make us feel better at the time they are administered.

But why do certain investment actions make us feel better, even when there is limited evidence that they will have a positive impact on our long-run outcomes? There are a multitude of factors at play here, but one interesting notion is the idea of an action bias, the phenomenon where in certain situations opting for action over inaction is heavily favoured. As an example of this, a group of psychologists studied the behaviour of goalkeepers during penalty kicks in football (soccer) and found that goalkeepers tend to jump left or right in order to save the penalty, wherein the optimal strategy is to stay in the middle of the goal[iii].

The researchers in the study argue that the tendency of the goalkeepers to dive in a certain direction is because the norm is for action, and their experience of a bad outcome (conceding a goal from the penalty kick) would be worse if they had ignored the norm and simply stood in the centre of the goal.  It would appear as if they did not take any action to prevent the bad outcome.

Now, I think there is a problem with this study – it argues that the best decision for a goalkeeper is not to move (they would save more penalties if they stood stock-still).  This is, however, founded upon the assumption that the penalty taker has not decided to kick the ball into the centre of the goal after seeing the goalkeeper move first.  In fact it is common for high quality penalty takers to wait for the goalkeeper to move and then strike the ball.

Even with this caveat*, the study makes a valid point about behavioural norms and how, in certain situations, we will view the simple act of doing something more favourably than doing nothing, despite there often being no compelling evidence that such activity will be beneficial to us.

In the investment industry, it seems irrefutable that there is a preference for action over inaction – amidst the incessant newsflow, erratic price fluctuations and obsession with the latest headline risk, the urge to do something can be irresistible – what if I miss out?  What if things go wrong and I have done nothing? How can I just sit here when all of this is happening? What will clients think?

The stress and anxiety created by such an environment mean that actions of questionable validity (on average) can prove a powerful short-term ameliorative – making changes based on what is happening now will likely feel good, for a time. The problem is they will often come at a long-term cost.

* Never let reality get in the way of an academic reference.


[ii] Shiv, B., Carmon, Z., & Ariely, D. (2005). Placebo effects of marketing actions: Consumers may get what they pay for. Journal of marketing Research42(4), 383-393.

[iii] Bar-Eli, M., Azar, O. H., Ritov, I., Keidar-Levin, Y., & Schein, G. (2007). Action bias among elite soccer goalkeepers: The case of penalty kicks. Journal of economic psychology28(5), 606-621.

What are the Chances of Finding an Active Manager with Skill?

For the purposes of this post, I will ask you to suspend your disbelief for a few minutes.

Assume I am talented fund selector and can differentiate between skilful* and unskilful active fund managers with a 65% success rate**.  I have an investable universe containing 500 active funds.  Of these 500 funds, 30% of the managers possess skill (if only).  If I select a manager from this universe, what is the probability that I can correctly identify whether they have skill?

There are four possible scenarios:

a) The manager has skill, which I correctly identify: 19.5% chance

b) The manager has skill, which I mistake for no skill: 10.5% chance

c) The manager has no skill which I correctly identify: 45.5% chance

d) The manager has no skill, which I mistake for skill: 24.5% chance

Despite having an edge in the identification of skill in active management, and the universe having a reasonably high proportion of skilful operators (compared to certain areas), the probability of me achieving my primary goal is only 19.5%.  More concerning is the differential between correctly identifying a skilful manager (a) and incorrectly identifying a manager with no skill as being skilful (d).  There is more chance of a false positive.

The crucial point here is that even if we believe that we have skill in a particular activity, we need to be acutely aware of the environment in which we are operating.   We tend to focus too much on how good we think we are at something when assessing our chances of success, and neglect the importance of the broader backdrop – what we might consider to be an outside view or base rate.  If we are operating in a barren opportunity set then the odds may be stacked against us even if we have expertise – the abundance of gold in a given area matters greatly for the success rate of even a highly skilled prospector.

In this simplified, one shot, example I have neglected a few important elements that are also crucial to success in active manager selection.  I have conflated skill and excess returns – the possession of fund management skill doesn’t necessarily result in the delivery of excess returns; it should certainly increase the probability, but there are no guarantees and the shorter the time horizon the more randomness will be the dominant influence in outcomes.  The possibility of bad luck is not insignificant.

There are also a host of acute behavioural issues that are likely to weigh on our ability to generate excess returns even if we identify a manager with skill***.  We are prone to invest in active managers following an abnormally strong period of returns, and mean reversion may then overwhelm any ‘alpha’ that can be derived from the manager’s skill.  We are also likely to sell at the wrong time – skilful managers will not generate consistent returns and during their more fallow periods the urge to capitulate will often be overwhelming.  Will you continue to believe a manager has skill even if performance is ‘telling you’ otherwise?

Even if you do not agree with the numbers I have used to create the above scenario; when deciding upon whether to participate in an activity that may involve skill it remains imperative that three issues are addressed:

Opportunity set: How much does skill influence outcomes? What are the chances of success if I have no skill?

Competition: If it is a zero sum game, it is crucial to know who the other competitors are – in the gold prospector example above, how many other people are doing the same thing and how good they are both crucial pieces of information. Michael Mauboussin has written extensively on this[i].

Level of skill: What would be an achievable and positive success rate?

Our tendency is to take an insular approach, focusing on our own perceived level of skill (which is often inflated), whilst ignoring the crucial external factors that will inevitably have a material influence on our outcomes.  This leads to us placing bets when the odds are not in our favour.

* For the purpose of this post, we can define skill in a very broad sense – fund managers with an approach that directly increases the probability that they can deliver excess returns ahead of their benchmark, other things being equal.

**  It is often said that a ‘hit rate’ for a stock picker above 50% is good enough to deliver excess returns – is this similar for fund selectors?

*** Let’s assume that skill is stable and persistent (even though it isn’t).

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

How Do You Identify Skill?

Many people involved in financial markets are engaged in a perpetual quest to identify skill – that is the attempt to seek out individuals or teams with the expertise to deliver abnormally strong investment returns. Whilst this is an understandable endeavour, it is also incredibly difficult.  In many domains and activities we can simply use outcomes as an effective proxy for skill, but in environments where uncertainty and randomness exert a significant influence, results alone can be woefully misleading.  Whilst an Elo rating may give you a robust guide to an individual’s ability to play chess; a track record of outperformance for an active manager will offer limited guidance on the underlying skill exhibited.

The vast, adaptive and reflexive nature of financial markets means that even if skill exists in certain areas, recognising it is hugely problematic. The complexity of the task means that investors typically default to a simple outcome driven approach – an effective heuristic in many other areas.

Given that focusing on outcomes alone is inadequate in an investment context, how should we approach locating skill in an activity where randomness heavily skews the results?   Rather than focus on one element, I think there are six important inter-related components that need to be considered: Specification, Calibration, Intention, Path, Outcome and Replication.

I will cover each in turn utilising a golfing analogy – although I don’t play the game, it is an activity that does incorporate both luck (less) and skill (more), and will hopefully serve to simplify the idea.

There are two golfers (Golfer A and Golfer B) both have taken one shot at par 3 hole and landed the ball very close to the flag – let’s say 3 feet. How do we determine whether each player has golfing skill?

Outcomes: If we were simply judging outcomes alone we might say that both golfers possess skill, as they have both produced excellent results.

Path: Understanding the path (how a result was achieved) can give us far richer information. Golfer A’s shot went arrow straight at the flag, Golfer B sliced their shot and it rebounded off a tree and onto the green.  Given this new information, we are emboldened in our view that Golfer A has skill, but now we are doubtful that Golfer B does – it looks as if they have just enjoyed a significant amount of luck.

Intention: It is very dangerous to assume that an individual has skill simply from observing an activity – if you don’t understand what they were trying to achieve beforehand.  If we know that Golfer A was attempting to hit his shot at the flag near which they landed their ball then we can have increased confidence that they possess skill.  But what if we knew that Golfer B was actually attempting to hit their ball onto the green after ricocheting off a tree?  Rather than believe that they had just been lucky, we might consider that they have superior skill to Golfer A because they performed a more difficult task.

Replication: Samples of one are never a good guide to skill and the more randomness in an activity the more evidence you require.  Although we might have a strong inclination that Golfer A and B both possess skill – with one example each we are incredibly vulnerable to being fooled by random occurrences.

Specification: When seeking to define skill, we need to be very specific about the activity in which someone possesses it.  Even if we witness both Golfer A and Golfer B repeat the exact same feat on numerous occasions – we can only be confident that they have skill in that precise task – we may infer that they are skilled golfers, but they might be terrible at putting, for example, a particular aspect of the game on which we have no evidence.

Calibration: All activities sit somewhere on the luck and skill continuum, and it is important to have a perspective on how much randomness and complexity there is in an activity before making any judgments about skill.  For example, landing a plane is dominated by skill with a slither of luck involved – if I witness an individual landing a plane successfully it gives me far greater confidence that they have skill in that task, than the confidence I might gain from watching someone hit a single good golf shot.  Trying to correctly calibrate the randomness inherent in an activity helps you to understand how much value there might be in the outcomes alone.

When chance is involved in an activity then we need to rely less on results. As we can see from the golfing example, understanding the different elements of the process can transform our view on whether we are observing skill or randomness.  When we are working to identify skill we should always be able to answer, at least, the following questions:

Specification: What is the precise activity in which we are attempting to identify skill?

Calibration: How much luck or randomness do we think is involved in the activity?

Intention: What is the objective of the activity?

Path: How has the objective been reached?

Outcome: What was the overall result?

Replication: How often has this process led to the same outcome?

In the investment industry we give pre-eminence to outcomes when determining skill. Even when we incorporate other factors, our perspective is often biased by the strong priors we develop after initially observing performance – if we see strong performance; we assume skill must be involved.  We are also prone to assume that apparent skill in one specific aspect translates across the entire spectrum of investment activities – someone is often considered a ‘good / great investor’- good at what, exactly?

Although skewed incentives and our obsession with outcomes make it incredibly demanding, the only way to even attempt to successfully identify skill is to understand not what the outcomes were, but precisely how they have been achieved.

Why Are Other Investors So Biased?

If you ask a fund manager why they believe that their investment philosophy can generate excess returns, they will almost inevitably state that they are seeking to exploit the behavioural biases exhibited by other investors that create pricing inefficiencies.  It is somewhat puzzling therefore that if you question the same fund manager about how they seek to address their own biases the response is either entirely unconvincing or evasive.

There is a stark contradiction in acknowledging an awareness of the influence of behavioural biases (to such an extent that the perceived viability of your investment strategy is founded upon it) but then willfully ignoring your own susceptibility.  Although there are competing explanations for this phenomenon the most compelling is the ‘blind spot bias’ – we see bias in others, but not in ourselves.  This concept was developed by Emily Pronin, Daniel Lin and Lee Ross, and reported in 2002[i] – the main conclusion of their research was as follows.

“We propose that people recognize the existence, and the impact of most of the biases that social and cognitive psychologists have described over the past few decades. What they lack recognition of…is the role that those same biases play in governing their own judgements and inferences”

In the study, participants were asked to rate their own susceptibility to various biases compared to the average American – these included: the halo effect, dissonance reduction and biased assimilation of new information.  Although the magnitude of the results varied, the direction was consistent – they considered themselves to be less vulnerable to bias than other people:

One obvious confounder for these results was that they may have reflected the participants’ perceived general superiority over the ‘average American’ – they were all Stanford University students; however, the same pattern emerged when they were asked to compare their capabilities to fellow students.

Our broad tendency to assume we are better than average was also contradicted in the same study as participants stated that they were actually worse than others when it came to certain personal limitations, such as procrastination and fear of public speaking.  It was only when specifically considering biases that the ‘blind spot’ appeared.

Given the issues with failed replications in psychological research, it would be easy to question the results of this work – particularly given that it was lab based, with a small student sample; reassuringly, however, the bias blind spot outcomes were repeated in a recent replication study[ii] (not yet peer reviewed). This was carried out across a far larger sample, which suggests a level of robustness in the main conclusion of the original[iii].

The bias blind spot theory certainly provides a convincing explanation as to why many investors seem to actively seek to exploit behavioural bias in others, whilst at the same time being reticent to acknowledge and address the issue from a personal perspective. But why do investors underestimate their own vulnerability to bias?  Below are five (of many) possible explanations:

Overconfidence: Our belief that we are better than others is probably the most obvious explanation; this issue is exacerbated for professional investors as there is undoubtedly a selection bias into fund management roles toward those with exaggerated levels of confidence in their own capabilities.  Inherent in the role of an active investor is the presumption that you are more skilled than other market participants – this might stretch to believing you are less subject to behavioural biases.

Cognitive dissonance: Whilst the overconfidence explanation focuses on how we perceive ourselves relative to others, cognitive dissonance is focused on how we judge ourselves internally.  There is an inherent friction in considering yourself a highly capable investor but also being susceptible to a range of behavioural biases – particularly given that these biases are often irrational and simplistic.  One way to alleviate this dissonance is to assume that you are above such biases.

Too complex / too difficult: It may simply be a case that dealing with personal biases is too difficult.  The list of biases is extensive, definitions are sometimes vague and they can often be contradictory.  For example, I recently attended a conference where there was a discussion of the endowment effect and how it can lead to fund managers maintaining winning positions for too long; whilst this is a valid explanation, it is in sharp contrast to the disposition effect, wherein investors are prone to sell their winners too rapidly.  Here we have two credible biases supported by academic research, but where their effects are directly contradictory.  Trying to incorporate such disparate information into our own decision making can be fiendishly difficult.

Personal narratives: When objectively and dispassionately observing another person’s investment decisions it is often easy to identify the potential biases that are likely to be influencing their judgement; however, it is far more challenging to adopt a similar approach for our own choices.  Instead, we are likely to create narratives around our own decisions that diminish the role of any bias – whilst our desire to sell a failing position might be due to outcome bias or myopic loss aversion; we will convince ourselves that there is a ‘pure’ investment rationale informing our view.

The sales message: Perhaps the reticence of professional investors to engage with their own bias is related to a general reluctance to acknowledge mistakes.  The sales message around active managers is about high conviction insights and the presentation of ‘hero’ stock performance charts – in at the bottom and out at the top.  Pitching to clients and discussing all of the irrational decisions you have made is not the route to convincing them of your skill.

None of these potential justifications are a reasonable excuse for understating our own behavioural limitations or failing to actively mitigate them.  Given how few genuine edges are available in the investment industry, it is baffling that this one remains widely neglected.

[i] Pronin, E., Lin, D. Y., & Ross, L. (2002). The bias blind spot: Perceptions of bias in self versus others. Personality and Social Psychology Bulletin28(3), 369-381.

[ii]  Replication study of Bias Blind Spot