Institutional investors who want to gain an investment edge can do so by controlling their behavioral biases.
That insight comes from Simon Hallett, co-chief investment officer at Harding Loevner, a Bridgewater, New Jersey-based asset management firm. Hallett presented guidance on avoiding cognitive errors at the Schwab IMPACT 2020 conference.
Hallett, whose firm manages more than $72 billion in long-only equity portfolio strategies, gave a talk called “Sources of Edge: What Behavioral Finance Can Teach Active Investors.”
The four sources are informational, analytical, behavioral and organizational. While investing involves some luck, there are investment professionals who succeed based on their skills. For example, choosing a stock that will perform well in the future involves having a knack for gathering information and data sets on long-term trends.
“Humans are flawed when it comes to making investment decisions,” Hallett says. “To facilitate good decision-making, you need to identify your edge, build a process and structure around it and reinforce it through the way you incentivize and compensate people. Finally, you must continuously improve to deliver strong performance in the future.”
The Role of Behavioral Finance in Investing
Fear, greed and behavioral finance contribute to understanding market movements, especially during COVID-19, wrote Omar Aguilar, chief investment officer of passive equity and multiasset strategies for Charles Schwab Investment Management, in a blog post.
“Behavioral finance seeks to account for the cognitive and emotional effects of human nature on investment decisions, attempting to understand how our innate tendencies lead us to behave,” he wrote.
“Some biases are primarily driven by emotions, including fear,” Aguilar adds. “And at the forefront of these fear-driven biases is loss aversion, which made its presence known as COVID-19 became a global pandemic.”
A challenge that investment professionals face is overcoming their emotions and learning to avoid cognitive errors. This can be done by establishing a process for making decisions, especially when investment decisions are made under conditions of great uncertainty, Hallett says.
“We believe that a behavioral edge can be obtained from implementing processes and structures to overcome many of these biases and then making sure there is discipline by group members in sticking to those processes,” he says.
An analytical edge is accomplished when investment executives can separate the signal from noise, Hallett says. This process involves structuring how research is conducted and committing to the characteristics sought in a company.
Confirmation bias can also play a large role in investment decisions.
“We see what we want to see, not what there really is,” Hallett says. “Research should be about gathering data, analyzing it and concluding. Too often, an analyst starts with a conclusion, sees data to confirm it and uses stories to make the conclusion more appealing.”
How Businesses Can Facilitate Good Decision-Making
Harding Loevner’s current culture is built around “collaboration without consensus,” where co-workers are encouraged to challenge each other in order to overcome confirmation bias, he says.
“The industry trusts the judgment of investment professionals so much that we want their best ideas, those in which they have the most conviction, without recognizing that conviction is another psychological bias that helps persuade, but is of little help in predicting the returns to securities that are owned by people of differing levels of conviction,” Hallett says.
Other factors that facilitate good decision-making at a financial firm are how the organization is structured and how employees are incentivized. An effective structure includes these aspects:
— Making incentives long-term in nature
— Demanding individual accountability, not group decision-making
— Aggregating individual decisions to deliver results to clients
— Communicating well with clients
Developing the right compensation at a financial firm can be challenging, he says.
“We are concerned that total compensation (short- and long-term) is competitive for unproven talent and very generous for proven talent,” Hallett says. “Our mix of short- versus long-term rewards is intentionally skewed toward the latter in virtually all categories of employee.”
There are several reasons why companies and managers choose this strategy. “It’s easier to align long-term rewards with skill compared to luck. Long-term rewards generally have a built-in retention incentive to encourage individuals who demonstrate their skills to continue to contribute here rather than elsewhere. And the skew toward long-term compensation sets up positive self-selection in recruiting individuals who are looking for a new home for their career rather than those with a transactional mindset,” he says.
These rules, incentives and the underlying process need to be accepted by everyone at a financial firm to create a strong culture, Hallett says.
“This helps explain why the firms that have strong cultures have a better chance of delivering good investment results,” he says.
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