Addressing cognitive biases will help investors net better results

R. B. Matthews, Doug McCutcheon and Emily Won

Many studies have shown that, after fees, the long-term results achieved by the majority of professional investment firms are below that of the broader stock market average. And as between individual firms, there is far less persistence of outperformance than you would guess. Given these facts, those of us in the investment management industry should be interested in improving our decision-making abilities.

Nobel Prize-winning psychologist Daniel Kahneman has dedicated his life to studying how people can make better decisions. In his highly praised 2011 book, Thinking, Fast and Slow, Dr. Kahneman described errors in human decisions arising from cognitive biases. His just published book, Noise, written with Cass Sunstein and Olivier Sibony, extends the analysis to deal with unwanted variation in judgments made by both individuals and groups.

Dr. Kahneman and his co-authors have chronicled the extraordinary level of costly mistakes, which could have been largely avoided, in areas such as medical diagnosis, insurance underwriting, bail hearings and financial forecasts. In these areas, there is often no immediate feedback as to whether a decision was correct or not. And there are few long-term studies examining the costs associated with the variability of these decisions. It is only through longer-term observation that the results of these decisions can be determined.

Not surprisingly, many of the professionals found to be committing these errors did not like having this pointed out. Why should these people, who have devoted their life to an activity, have to listen to an academic with no practical experience in the area? You might hear them say: “Those who can, do; those who can’t, write.” Typically, these decision makers chose to proceed as they always had, with their blinders firmly in place.

How does this apply to investing in the stock market? Investors (as opposed to speculators) decide whether to buy or sell a company, based on their view of whether the stock market is overestimating or underestimating the company’s future profit and, hence, its economic value. In essence, success in investing turns on the ability to accurately predict those future earnings.

Overconfidence in our ability to correctly forecast the future is one of the best documented cognitive biases. In predictive judgments, human experts are consistently outperformed by relatively simple formulas.

Despite knowing this, we are all reluctant to follow a systematic process rather than our instincts. We view today’s facts with hindsight, applying an assumed causation to everything that has happened. When we look at the past, nothing appears surprising. The result is that we expect no surprises in the future – a future that we falsely assume we can foresee accurately.

Dr. Kahneman explains how investors can improve their predictive judgments and consequently their results. Keeping an open mind – actively seeking disconfirming evidence – is extremely helpful.

So is thinking in terms of probabilities, something that is not intuitive to most of us. An example would be to take the “outside view” of a company under consideration. Investors should, for example, look at the historical rates of growth achieved by other companies of the same type and size. In trying to determine whether a business is likely to increase its revenue at 15 per cent a year for the next 10 years, it’s helpful to know how often similar businesses have (or have not) achieved that.

It is also useful, when analyzing a potential investment, to include in the analysis simple formulas or algorithms that have proven, over the long run, to be predictive of higher returns. One well-known example is the advantage of buying a company trading at a relatively low multiple of its earnings per share over the past year. There are many other relevant factors (the historical rate of growth, profitability and so on), and these can be combined. While some may choose not to rely entirely on a quantitative approach, it’s helpful to include in any analysis a systematic ranking of the companies under consideration, based on what are evaluated to be the most relevant measurements.

The authors of Noise point out that the odds of a good decision will improve if several people make entirely independent estimates and then base their decision, at least in part, on the average of the results. Having each person decide completely independently is crucial. If you had four witnesses to a crime scene, would you want them to talk to one another before testifying?

The efficacy of this “wisdom of crowds” approach has been known for many years, but is rarely followed by investment firms – in part because of a desire to avoid disagreements. It may also be easier to promote a star investment manager than a group of professionals. The authors suggest the average estimate can be treated not as the final answer, but rather as the starting point for a discussion and ultimate decision. Their advice is “don’t eliminate intuition, delay it.”

Given the proven advantage of following the procedures described above, and the cost of current practices, it is dispiriting that decision makers across professions continue to resist change.

However, for some open-minded active investment managers, Dr. Kahneman’s process may well represent the refinement needed to finally produce net results that, over the long run, do indeed outperform the stock market.