Investment Bias - How heuristics and bias perpetuate bad investment decisions
HOW EFFECTIVE ARE WE AT CONSUMING INFORMATION?
Would it be fair to assume that, casting your mind back to your formative years, the world today is in many aspects noticeably different? The advent of social media, the internet and industrialisation has seen us bombarded with a flurry of opinions. While these factors increase productive capacities, they can also lead to information overload. The human mind is adaptive in that it’s able to filter through and harvest what it wants from this onslaught of information. Essentially, we eliminate “junk” and process “relevant” information via a series of shortcuts. This allows us to solve problems, make judgments and decide with sufficient fluidity. Cognitive science describes this process as heuristics.
IN SIMPLE ENGLISH
The mind draws on past experience, finding easy ways of calculating numbers, linking plausible items and leveraging rules of thumb to sift through the information debris. A simple example would be when a person judges a situation on the basis of similar situations that come to mind. He or she then extrapolates and makes decisions on this basis. A common-sense approach to solving problems or to approximate an outcome based on educated guessing can also be considered everyday heuristics.
HOW HEURISTICS AND THE RESULTANT BIASES THAT FOLLOW AFFECT INVESTMENT DECISION MAKING
In contrast, decision making in investment management isn’t as effortless, and is fraught with subjectivity. Seasoned, well-heeled, expert, amateur, hobbyist or rookie -- none are spared. Each brings a unique, historic perspective to the decision-making table. The difference between “betting the house” and “stable and steady returns” is knowing when to rein in your proverbial horse.
The subject matter at hand delves deep into cognitive psychology, and the seminal paper by Kahneman & Tversky, 1974, was among the first to study heuristics, introducing factors such as representativeness, availability and anchoring. Let’s relate this closer to the “so-called” tangible ambit of investments.
Representativeness
This heuristic represents the tendency to draw unwarranted conclusions about an asset manager with a limited set of data at hand. We can associate a good brand with a good company without having much appreciation of the underlying facts. For example: In a fund-of-funds business, having a preference for a renowned asset manager as an anchor professional or disliking another manager without much insight into his or her ability to manage a particular strategy.
Availability
This heuristic represents the tendency to make decisions on a presented set of data whether it’s meaningful or not. It has an almost bubblegum-like effect in that a sticky thought is easily retrieved by your mind.
For example: Recent media coverage that sensationalised an asset manager for significantly outperforming the benchmark when other managers had failed to do the same. The risk is that if the performance was not expected, the manager could in fact deliver an equal underperformance.
Anchoring
This heuristic represents the tendency to focus on specific events used as a central reference point in decision making. It almost invokes a sense of fear and potential for excessive risk aversion.
For example: An aversion to asset managers that apply a quantitative approach to investing which performed poorly over a recent period; or an investment professional’s dire hedge-fund performance at a previous firm, which may be irrelevant today.
One could argue that those entrusted with the stewardship of capital have sufficient skill in managing investments. However, being human makes us susceptible to the above biases, which can influence or cloud objectivity.
It is these inclinations that inevitably lead to biases, and that make for unsound decision making.
The list below details some influential biases that swing votes
