A Few of Our Favorite Cognitive Biases

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On a whim we recently conducted a search for the best definition of the term “investment management”. Unfortunately traditional dictionaries don’t contain the term so we turned to online sources such as Investopedia, Wikipedia, Investorwords.com, et. al.

For the most part definitions we discovered were little more than “the process of managing investments” which isn’t particularly illuminating. Our definition of investment management would be: The ongoing process by which a person or firm identifies investment opportunities, contemplates appropriateness in the context of their clients’ portfolios and takes action in a manner consistent with the terms of the adviser-client relationship.

This definition has many points which should be addressed, such as the idea that investment management is an ongoing process rather than a “once-a-quarter” or “when a client calls” account review. It also speaks to the existence of different adviser-client relationships. However in this article we look to focus on two of the three action items within our definition; identifies, and contemplates. We exclude the third action item “takes action” from our commentary today as it is fairly straight forward. For discretionary managers “takes action” may be placing a trade while for others it may be submitting a recommendation to a client.

However “identifies” and “contemplates” are intellectual rather than physical actions. It is much more difficult to evaluate the quality of your managers’ processes when the action is in their head. Often historical performance is used as a measurement to gauge the efficacy of a manager’s investment approach. The proof is in the pudding, is it not? Historically good performance suggests a good process and any other result would suggest something other than a good process. Therefore if good performance, i.e. good process, has yielded good performance in the past why would it not continue to do so? We wonder if that were indeed true why then would the statement “past performance may not be indicative of future results” be ubiquitous?

We submit that part of the reason is investment approaches or styles come in and out of favor as different types of assets come in and out of favor. For example, over the last several years large cap growth stocks have performed well relative to large cap value stocks. However that has not always been the case. There have been and eventually will be periods where large cap value stocks perform better than large cap growth stocks. If a manager is a large cap value manager exclusively (such as a large cap value mutual fund manager) that manager may be restricted from buying the types of stocks that are performing the best. In this example does historical performance adequately inform an investor as to the quality of the manager’s ability to identify and contemplate investments?

Be assured we do not advocate a lesser importance placed on historical performance. To the contrary, performance absolutely matters. We just believe that there is value in a deeper understanding of your investment manager. Are they rigid in their thinking and approach? Do they believe their approach is the best way in all markets and why? Do they have the ability and willingness to change as markets change or do they advocate riding out volatility across market cycles?

When it comes to decision making we believe it is important to acknowledge that biases exist and influence each of us. While we can never rid ourselves of our cognitive biases an attempt to identify and understand them may help us to make better decisions. Ultimately isn’t the ability to make good financial decisions what clients expect?

Here is a quick list of some of the cognitive biases financial advisers face:

Anchoring: The tendency to rely too heavily on a single piece of information, often the first piece we acquire.

Availability Heuristic: A process by which the more we encounter a piece of information (repetition) the more plausible it becomes, i.e., say it enough times it becomes true.

Bandwagon Effect: The tendency to believe things because many other people believe the same, i.e., Groupthink.

Clustering Illusion: The tendency to overestimate the importance of small runs, streaks, or clusters in large samples of data.

Endowment Effect: People often demand higher compensation for something they own than what they would be willing to pay for it.

Gambler’s Fallacy: The tendency to think future probabilities are influenced by past events when in fact there is no relationship.

Hindsight Bias: The tendency to see past events as being predictable, i.e., I knew it all along.

Irrational Escalation: The tendency to justify increased investment in a decision based on the amount of prior investment despite new evidence showing the initial decision was probably wrong.

Mere Exposure Effect: The tendency to express undue liking for things merely because of familiarity with them.

Sammelweis Reflex: The tendency to reject new evidence that contradicts a paradigm. (Academic research shows selling under-performing fund managers and buying outperforming managers is a flawed approach)*.

Status-quo Bias: The tendency to like things to stay relatively the same.

This is by no means an exhaustive list, nor is it reasonable to expect that every decision a manager makes is filtered to ensure undue influence from all potential cognitive biases are minimized. Still, if you take a moment to consider these biases I suspect you will quickly come to realize that some managers appear to exhibit cognitive biases in their approach. We submit that markets are so complex and dynamic that good managers will challenge themselves to resist the temptation of the Mere Exposure Effect or Status-Quo Bias and others in order to make the best decisions they can for their clients. We believe we are a little more contemplative than your typical manager. Of course that may be due one cognitive bias we have yet to mention.

Bias Blind Spot: The tendency to see oneself as less biased than other people.

We’re still noodling that one.

*Morey, Matthew R., Kiss of Death: A 5-Star Morningstar Mutual Fund Rating? (September 2003). Available at SSRN: http://ssrn.com/abstract=455240 or http://dx.doi.org/10.2139/ssrn.455240

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