Real Returns by Dan Mikulskis

Reading Time: 8 minutes

The evidence is undeniable. We all have brains that are set-up to make consistently bad choices when it comes to domains that are complex, ambiguous and unpredictable – like investing. We overestimate our own ability, screen out information that conflicts with our pre-conceived views, we fear losses, and anchor to what feels well known and familiar. We are a sucker for stories and believe that scenarios with a convincing narrative associated with them are more likely than they really are (among many other pitfalls). And yes “we” means not just individual retail investors not just Terry the Trader or Pete the Portfolio Manager, it most definitely includes you.

Worse, when you put a group of us together, social and other effects come in to play which means strange things like cascades and polarisation can happen, information ends up not being shared effectively and the group ends up making worse choices than an individual.

That’s a problem for the domain of institutional investing where groups are trusted with making decisions regarding billions of pounds of investment and securing the financial futures of millions.

If we can help those groups make less biased decisions this ought to have a large investment and social dividend, how might we do that?

Institutional investors like pension funds tend to think a lot about Governance:the organisational committees and process around making decisions.

When it comes to investing I think “governance” should be defined as designing a decision process that is as unbiased as possible.

As NEPC observed in their 2016 paper – good governance is the cornerstone of a successful investment program.

In order to do that we need to understand carefully the myriad ways in which individuals and groups can make biased and irrational decisions when it comes to investing – and the fact is, there is so much evidence showing that we are, in fact biased, and that groups can often be more so, that it is a demanding task indeed to remove or minimise the impact of this (see for example my previous blogs on behavioral biases in investing and the problems with group decision making).

Understanding the core biases is a good first step but simply telling ourselves not to do something doesn’t tend to be massively effective – and up until recently the “so what” has been a bit lacking when it comes to behavioral finance. The good news is that there is more and more thinking out there now on ways to actively correct for the biases that we have.

Here are some suggested principles to design governance systems to try to counteract these tendencies. (in brackets are the specific biases that each step addresses).

1. Name it to tame it. Clearly spell out the extent of our biases and keep it somewhere where all can see, such as a statement of beliefs at the front of every key board paper. Stating things like “we will be biased toward the status quo / we will tend to ignore information that conflicts with our beliefs / we will be overconfident / we will be prone to believe in stories and judge things more likely and significant if they can be easily called to mind. By writing these biases out, acknowledging and “owning” them is a good start. We would do well to remember that there is evidence that the higher someone’s IQ is the MORE supporting explanations they tend to generate for their narrative so they can suffer worse from confirmation bias, not better. (Confirmation bias, cognitive dissonance).
2. Spend time on beliefs. Taking time to spell out beliefs and principles will pay back in the long run as they provide clear guardrails to support thinking and avoid solving every problem from scratch. Spelling out beliefs and investing according to them should also provide the conviction needed to hold onto strategies through the inevitable periods of under performance (loss aversion)
3. Establish a truth-seeking cultural contract. Have all your decision makers sign up to a simple charter that encourages dissent, prides accuracy and intellectual honesty. You could even consider the equivalent of a “swear jar” to create a stop-and-think moment whenever someone says something that indicates bias might be at play: “I’m certain, that has never, that always, you are wrong” … (Confirmation bias, ego, cascades, hidden information).
4. Enter a Ulysses contract. Bind your future self in advance to less biased thinking. Framework thinking is less biased thinking. Page two of each board pack should contain the same decision making framework, which focuses the mind on a pre-agreed set of key variables, those that matter most to overall outcomes. That’s not to say that other things can’t be considered, but by always starting with the key things, we can stand a chance of avoiding focusing on what’s available rather than what’s important. (availability bias).
5. Think hard about risk-budgets. Working with an overall risk “budget” (however defined) sets expectations in advance for what expected losses will be in periods of under performance, making it easier to hold the strategy steady when it suffers inevitable losses. Understanding the same for each individual manager or strategy in the portfolio helps manage emotional reactions to losses in particular portfolio segments. No risk model is perfect, and some have significant drawbacks, but used properly it can be a useful tool. (loss aversion, emotion).
6. Divide and conquer. Fight overconfidence and ego bias by having tightly defined remits for each role or committee and sticking to them strictly – we may love the idea of the sweeping decision maker or table-pounding investment guru, but a lot of evidence suggests we are not well served by these roles. (ego and overconfidence).
7. Focus on small groups with defined roles and in-advance accountability. A lot of evidence suggests that one big committee of the great and the good sitting round a table doesn’t produce good decisions. A survey by NEPC showed that most investment committees have more than 7 people – but believe they should be smaller. Dividing the group up with specific tasks (eg to work up counterfactual competing alternatives, play devils advocate or do a pre-mortem) can help this. If each group also knows in advance that they will be accountable to another on specific metrics (be that manager performance, strategy choices, risk or returns), this is likely to improve truth-seeking and reduce self serving behaviour. (groupthink and cascades).
8. In oversight, check for bias, be skeptical but don’t second guess. The role of an oversight committee shouldn’t be to second guess the work of the underlying group, but to specifically seek out potential biases in the work (have they been too anchored to status quo, are they making overconfident predictions, what’s the track record and expertise in the area, are they ignoring information that doesn’t fit their view). Taking a skeptical, but not confrontational viewpoint particularly when self re-enforcing results are concerned is also key. (status quo, ego bias, overconfidence, cognitive dissonance)
9. Fight social influencing with anonymous instant voting (so many systems are available now such as loomio and others). There’s so much evidence that going “round the table” for views just produces a biased “cascade” in most circumstances. (social influencing, social loafing, cascades).
10. Focus on process. It’s about the swing not the shot. Emotion is a killer when it comes to investment decisions, particularly when you, or your managers are losing money. But judging everything (including yourselves, your committees, your managers) by the agreed process that you are following is a good way to keep you on the straight and narrow. (emotion, loss aversion).
11. Focus on positives and negatives. Five things that are going well/could go well, five reasons things are going badly. Forced focus on both sides of an argument or perspective helps loosen anchoring, “primes” balanced critical thinking and get round confirmation bias. (perspective, cognitive dissonance, hidden information)
12. Review, reflect. Log your decisions (with reasons). Regular honest retrospectives can help fight ego and overconfidence, learn from mistakes and recognise the existence of information that conflicts with our beliefs. Look for mistakes in decisions that turned out well and good moves in decisions that turned out bad. Logging decisions and reasons makes it less likely that outcomes could be mis-attributed to luck or skill (ego, overconfidence, cognitive dissonance, attribution error).
13. Pre-commit. Log what would cause you to change your mind on a decision in advance – (perhaps a key man risk in your manager, a significant business change, style drift, performance inconsistent with the agreed process). By setting this out in advance it makes taking a decision – be that taking action or staying put – easier and less emotional. We’ll always have a bias to take action and do things, to be in control, but often when it comes to investing this is exactly the wrong thing to do – and staying put is easier if we have a clear decision criteria in advance. (loss aversion, emotion, bias to action, overconfidence).
14. Take a blank sheet. Every so often, annually perhaps ensure that your process involves building up a portfolio from a blank sheet of paper. (anchoring, status quo, conservatism).
15. Avoid black/white to seek out hidden information. One of the most pernicious failures of groups is the fact that information held by only one individual tends not to be brought to light, while the group focuses on the information they all know to be true. One way of helping this is to avoid right/wrong thinking on key issues by embracing uncertainty and thinking in terms of degrees of confidence – which encourages sharing of conflicting information, rather than black/white, which doesn’t – as having to suggest someone is wrong grates against the usual social contract. (hidden information, cascades).
16. Diversity of thought, well deployed. This is much harder than it sounds. While it’s by now commonly known that diversity of thought/ideas brings dissent, and therefore a real way out of the self-serving and self re-enforcing bias to which we are so prone simply throwing a load of diverse voices together will often lead to discomfort, tension and perhaps even outright hostility. It might also lead to a stalemate and backfire by maintaining the status quo in the absence of agreed-upon ways forward. The key is to manage it in the right way (reasonable diversity, or a diversity of reasonable views) so that the inevitable tensions can be navigated for the ultimate benefit of the group – a lot of the other suggestions here relate to practices and structures that can try to help this.
17. Reward accuracy, dissent and intellectual honesty with social recognition. So much of the issues with group decisioning revolve around the negative side of social influencing but we can use this to our advantage in finding ways to reward those behaviors that are most helpful – accuracy and intellectual honesty. This isn’t easy at all but the right leader (or chair) can go a long way to creating the environment where this can work.

Ray Dalio has written a by now well-known book detailing how he built what he described as an “idea-meritocracy” at his firm Bridgewater – addressing precisely some of these issues in his book: Principles (if you want a short summary of my takeaways and what surprised me about the book, check out this post). Perhaps the popularity of Principles across many domains well beyond finance is partly explained by the burning demand for practical guides to solving some of these problems – intuitively we know this is an issue and are attracted to solutions. It will be interesting to see what other case studies emerge through time.

These ideas could in theory be applied well beyond the domain of investing – any situation where you have group responsibility and decision making might benefit.

Tweet me if you have any other thoughts or suggestions.

To read more about behavioral investing from true experts on the topic I would strongly recommend Daniel Crosby’s book The Behavioral Investor (which I summarise here but read the full book if you can, it is excellent), the ever-entertaining James Montier and his Little Book of Behavioral Investing or the work of Greg Davies. or Joe Wiggins.