In finance 101 you learn all about the two types of risk: systematic (market) and non-systematic (idiosyncratic) risk, but conventional teaching tends to ignore a third risk – Behavioral risk, which can be the most important. >> From @danielcrosby ‘s excellent book The Behavioral Investor which provides both a new taxonomy of behavioral biases from an investing perspective, but also a solid and practical guide to trying to avoid or at least minimize them. Honestly I think this book should be required reading for everyone working in the asset management and advisory industry. I think the book is aimed at individual investors but many of the observations apply equally well to the individuals and groups responsible for institutional investment.
The book is well worth reading in its entirety, but here’s a quick summary of my takeaways on the causes of, and means to address the behavioral biases most relevant to investors.
You aren’t as smart as you think you are. Almost no-one is. Yet time and again we over-estimate our ability to predict and forecast, and we under-estimate the role of chance and luck. And worse, once we have made a prediction we have a tendency to avoid information that conflicts with it and see only information that supports it. Unfortunately it has been shown that when domains become more complex and ambiguous, we are wrongly prone to becoming more confident in our abilities.
Address by: the key here is diversification. This guards against us getting too carried away with our ability to forecast returns in any one asset class or strategy. Ego can cause us to “double down” on positions we’ve taken, even where we don’t rationally have reason to think we have an edge in that area (debates around currency hedging come to mind). The more we can put in place mechanisms to stop ourselves doubling down the better. Force yourself to regularly focus on the positive and negative information and commit to annual mea culpas which focus on what went wrong. Consider take a leaf out of Charlie Munger’s book and consider inversions and counterfactuals to all decisions.
We synthesize happiness, so we tend to over-value what we have, and punish ourselves heavily (with regret) for taking actions that turn out bad. Through the pain of regret, losses loom larger than equivalent gains. Faced with a torrent of literally thousands of decisions a day we opt for the status quo as a default in many cases. And while by and large this is not a terrible rule of thumb when it comes to investing it can lead to irrational decisioning in holding on to assets for too long, or a reluctance to re-position the portfolio, or diversify.
Address by: accept upfront that volatility and (on-paper) losses are part and parcel of investing. Set a risk-budget to try and quantify how much you expect to lose in the natural course of market cycles and manage your investments to this, so you have a good idea upfront of how ugly things are likely to look at some point in the future. Try to avoid fear-inducing situations. Test for home-country bias in portfolios and flip the script (ask what if we were starting from a blank sheet of paper or owned asset class B instead of A). Look through multiple risk lenses and don’t gravitate to an excessive focus on short-term only measures.
This is perhaps the most pernicious of the biases as I think it is least recognised. Simply put, we just do not appraise the likelihood and impact of things rationally, but we place far too much emphasis on things that loom large in our recollection, or are easily called to mind (in the literature this is referred to as availability bias). And of course there is not shortage of examples of this in finance: Brexit, the next recession, the housing market, trade wars, emerging market currencies. On any given day any number of these may be looming large in our minds but that does not necessarily mean they are likely, impactful or cost-effective to hedge.
And we LOVE stories. Our minds are set up for stories, not probabilities. So time and again we will overestimate the likelihood and misjudge the impact of something that has a convincing story behind it.
Address by: Take a leaf out of Odysseus’ book (who famously tied himself to the mast to resist the call of the sirens). Use a process and framework for investment decision making, to try and force yourself to focus on the most important points. Beware of managing to scenario testing. Yes, scenario tests can be a neat tool for getting a handle on risk in a portfolio, but it is almost impossible to construct scenarios in an unbiased way and they are always likely to focus on the available rather than what really matters.
Emotional decisions are not always rational decisions. Well I think we all know that but few places can punish such a behavioral “glitch” as badly as the financial markets where a rational and probability-based approach to decisioning is what is needed but is just the opposite of what we are likely to find when we are dealing with painful investment losses (either realised or on paper). Strong emotion will always result in an over-reliance on heuristics, and cause us to take shortcuts such as underestimating the risk of pleasurable things (simply bucketing things into good/bad).
Address by: trusting the process. Don’t try to make big decisions “on the fly” in reaction to events as these will be subject to bias. Have a process and follow through on the process (and make sure anyone who manages money for you does the same).