Africa-Press – South-Africa. Portfolio managers can, like any other human being, find their judgment clouded by biases. Joseph Pearson and Anton Pietersen explain how to guard against these biases for better decision-making.
Even with a vast amount of up-to-the-minute data at their fingertips, portfolio managers are, like the rest of us, prone to natural human biases like overconfidence and lazy thinking. This can cloud their judgement in making rational investment decisions. In a professional asset management environment, there has to be systems in place to control these tendencies.
Nobel Laureate Daniel Kahneman explained the human mind as an alliance of two ‘systems’. The first is the primitive brain designed around survival, which is capable of rapid, effortless assessments but also vulnerable to cognitive bias. The second system is the modern brain, which allows us to grasp abstract concepts and wrestle with complex decisions.
Unfortunately, system two is relatively slow and lazy. It demands conscious effort and generally checks in with system one before making a decision. So it imports those unconscious biases.
Here are some of the classic biases which can influence the judgement of even the most ‘rational’ investor.
Hindsight bias: We are tempted to believe that we perfectly understand the past and can therefore predict the future. Google’s success looks obvious in hindsight. But was it the product of luck as well as judgement? In the business world, as Warren Buffet points out, “the rear-view mirror is always clearer than the windshield”.
Loss aversion: Given a choice between a guaranteed loss of R750, or a spin of a wheel giving a 75% chance of losing R1 000 and a 25% chance of losing nothing, people tend to go for the gamble. Loss aversion suggests that people are so reluctant to lock in a loss that they will risk an even bigger loss just to have a chance of escaping intact. To quote Kahneman: “An investment said to have an 80% chance of success sounds far more attractive than one with a 20% chance of failure. The mind can’t easily recognise that they are the same”.
The narrative fallacy: Narratives are an effective way to store information. If you were asked to memorise 50 random numbers, it would be a daunting task. But if you were told that the 50 numbers were the even numbers between zero and 100, it would take no effort at all, since they are described by a system, or narrative. In financial markets, the narrative fallacy emerges in the temptation to extrapolate historic trends into the future and falsely impute a causal link between events. This is particularly dangerous for portfolio managers, whose job is to understand the range of future outcomes.
Overconfidence: “It ain’t what you don’t know that gets you into trouble. It’s what you know for sure that just ain’t so”. Wise words indeed from Mark Twain. Overconfident managers build excessively concentrated portfolios as the benefits of diversification dim along with their sense of their own talent. A strong risk management framework is the only remedy for overconfidence.
Confirmation bias: Confirmation bias is the tendency to emphasise data points that confirm our existing beliefs and ignore those that contradict them. This is a deep bias that can pervade a manager’s investment process. It exacerbates loss aversion and undermines the manager’s ability to accept that events are not playing out in their favour and cut their losses.
To offset these natural human tendencies, it is critical that investment managers draw on advanced analytics and insights. This will enable them to improve their investment decisions, recognise their cognitive biases and mitigate risks.
If, for arguments sake, the investment managers were Formula One drivers, the advanced analytics they would access would effectively be their pit crew. And, ideally, the pit crew’s function is to alert the driver to any potential hazards around the next bend, helping them stay off the gravel and on track. For investment managers, the advanced analytics and analysis should:
Inform and challenge the portfolio manager: The analytics should dig deep into the portfolio’s construction, individual investment decisions and trading patterns. Ideally it should play ‘devil’s advocate’, providing alternative or contrarian views to help the managers re-examine their investment process.
Revisit the thinking: Ongoing conversations should be held with portfolio managers to highlights trends or possible biases emerging in their portfolios.
Incorporate insights: Behavioural insights should aim to ensure that investment processes keep evolving and attempt to reduce the size and impact of adverse outcomes. It should help portfolio managers visualise their portfolios’ resilience (or fragility) under various stressful scenarios.
The outcome of this process is that portfolio managers construct more resilient portfolios, are better able to manage risk and can achieve better results aligned with their mandates.
Although we live in an era of astonishing computing power, building effective investment portfolios demands human flair and creativity. To be most effective, that creativity has to be linked with the science of analytics to alert investment managers to their innate bias and help them to manage it.
Anton Pietersen, Senior Specialist: Investment Analytics and Joseph Pearson, Head: Analytics, STANLIB. The views of columnists published on News24 are therefore their own and do not necessarily represent the views of News24. News24 cannot be held liable for any investment decisions made based on the advice given by independent financial service providers. Under the ECT Act and to the fullest extent possible under the applicable law, News24 disclaims all responsibility or liability for any damages whatsoever resulting from the use of this site in any manner.
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