KNect365 is part of the Knowledge and Networking Division of Informa PLC

This site is operated by a business or businesses owned by Informa PLC and all copyright resides with them. Informa PLC's registered office is 5 Howick Place, London SW1P 1WG. Registered in England and Wales. Number 3099067.

Informa

Incorporating behavioral science into investing

Dan Kemp, Chief Investment Officer (EMEA), Morningstar Investment Management Europe, discusses a different perspective on investment and how an application of behavioral science can impact your investment process.  This is the first in our series of articles on auxiliary thinking.

As investment management has become more competitive, long lunches and tips from brokers have been replaced by a welcome focus on improving outcomes for the end investor.

Against this background, investment management businesses are increasingly interested in using behavioural finance to improve decision making, taking advantage of scientific breakthroughs to strengthen their value proposition.

Yet, many business leaders are still unsure how to do this in practice, so we offer a few practical tips to get you up to speed.

Always room for improvement

The first step is to be open to change. That is, an investment management team needs to accept that there is a need for improvement in their decision making.

This can be difficult for highly-paid, well-educated professionals, necessitating a team culture that is focused on helping the end investor rather than aggrandising the fund manager or enriching the owners of the investment company.

"While most investors will diligently seek as much information as possible to support the positions they take, more information is not always helpful."

Embedding a culture of continuous improvement can be done in several ways. This concept is multifaceted, from the lowest intensity (holding presentations and training) through medium intensity (book clubs) and high impact (utilising tools and tests to reveal the strengths and weaknesses of the team).

The path you choose will depend on the starting point of the team and how quickly you want to make progress.

Change implementation

Once the team accepts the need for improvement, the next step is to implement changes that help the team make better decisions.

While there is a great variety of changes that a business could consider, Greek mythology (and specifically the story of Odysseus sailing past the Island of the Sirens) provides a simple yet comprehensive guide to the key options available.

Much like the modern leader of an investment management business, Odysseus was concerned that his crew would make poor decisions under pressure, hence making two preparations to keep them safe.

First, he had his crew stuff wax in their ears. This enabled them to block out the noise and continue rowing undistracted by the sirens.

While HR teams reject forcing wax into the ears of investment managers, we can create a similar effect by controlling the information that informs their decisions.

While most investors will diligently seek as much information as possible to support the positions they take, more information is not always helpful.

Research by Claire Tsai[1] and others shows that increasing the information experts receive typically increases confidence in our predictions without improving the accuracy of those forecasts to the same extent.

To counter this challenge, we can seek contrary rather than confirming evidence when forming a view.

Establishing the framework

The next step is to create an execution framework. This is best done via a principle-driven structure that helps decision makers understand when to act and when to sit still.

For example, big news stories or a market price shock can encourage our natural tendency to make rapid changes, ultimately leading to higher costs and lower returns.

For those who want or must expose themselves to the noise, Odysseus has a different lesson. Rather than block your ears, follow his example and have yourself tied to the mast, preventing action based on external stimulus.

"As investment management has become more competitive, long lunches and tips from brokers have been replaced by a welcome focus on improving outcomes for the end investor."

While investment management firms often boast of the speed with which they can react to market circumstances, it is worth remembering that high turnover increases costs and makes it harder for managers to beat the benchmark.

Rather than the most responsive, it is often the least animated managers that deliver the best returns for investors (as demonstrated by research from Martijn Cremers[1]).

Team motivating; collective buy-in

The final step is to get collective buy-in from the team. Motivating change is inherently difficult, yet it tends to work best if the team can see the benefits and feel empowered by the change.

Therefore, rather than tie the hands of your investment team, utilise a peer-review process that encourages sound behaviour and supports the interests of the end investor.

We have also found that having a set of clear investment principles helps guide better decision making. These principles keep the team aligned, creating a standard of behaviour and social norms.

While the above is designed to create iterative improvements, the most important message of Odysseus is that there is no substitute for preparation, which remains true today.

It would have been pointless for him to institute these measures while under the influence of the sirens, instead deciding to plan ahead.

While behavioural science may be of most help when we face volatile markets, the time to make improvements is now.

[1] Tsai, Claire I. and Klayman, Joshua and Hastie, Reid, Effects of Amount of Information on Judgment Accuracy and Confidence. Organizational Behavior and Human Decision Processes, Vol. 107, pp. 97-105, 2008. Available at SSRN: https://ssrn.com/abstract=1297347

[2] Cremers, K. J. Martijn and Pareek, Ankur, Patient Capital Outperformance: The Investment Skill of High Active Share Managers Who Trade Infrequently (December 1, 2015). Journal of Financial Economics (JFE), Forthcoming. Available at SSRN: https://ssrn.com/abstract=2498743 or http://dx.doi.org/10.2139/ssrn.2498743

Get articles like this by email