We met behavioural finance specialist, Ben Kelly, to talk to him about how he thinks behavioural biases will influence the future of investing. Ben works with investment managers and tries to provide practical, long-term solutions for their costly behavioural biases.
I came across the subject whilst at university in St Andrews. I did an undergraduate degree in Chemistry and had always wanted to be an airline pilot but failed the medical so I had to have a rethink. I had done some Economics modules as part of my degree and enjoyed them, so I thought, why not do a Masters in Economics? The conclusion of my Masters coincided with a fairly flat job market and I didn’t have anything lined up. The Economics department offered me the chance to do a PhD which I happily accepted. They suggested I speak to a gentleman who was working in a “funky area of economics” called experimental economics. Having spoken to him he recommended a number of academic studies to read on sunk costs in the oil industry which I thoroughly enjoyed as they were more practical than theoretical so I eventually decided to embark on a PhD in Experimental Economics. Behavioural finance was a subject I stumbled on through the discovery phase of my research and it ultimately became the focus of my thesis.
After finishing my PhD in 2007, I joined the graduate scheme at BlackRock and my behavioural finance expertise ultimately took me towards their knowledge sharing/think tank area of the business. I ended up being the ‘go-to’ person for any behavioural finance related requests, working with the investment teams on behavioural biases in their investment process. It was fun and quite hard at times to try and untangle these biases but the difficulty was always; what are the long-term, practical solutions to combat these biases?
It’s the solutions I concentrate on now, having left BlackRock about a year ago. Every case is unique and when it comes to dealing with your emotions, one solution doesn’t fit all.
That’s probably because developing solutions is very difficult and there isn’t really a generic answer. A solution that works well for one person may not have the same impact with another. Ultimately, if we can’t use behavioural finance to make us better investors, discussions about biases are just nice stories. For the subject to have any longevity, we need to start finding solutions or designing processes that eliminate bias.
When it comes to bias and having to make a difficult decision, relying on a robust process is the best thing to do.
There is currently a trend in that direction and to a degree, they do eliminate traditional biases but I don’t think they solve every problem yet. I recently visited some quant and algorithm-trading teams in the US and initially didn’t think I would find much because computers don’t really carry biases. However, it quickly became clear that there was bias around how the algorithms were designed. The head of the team decided how stringent this particular algorithm had to be and some members of his team disagreed with him, so there were all these biases floating around the room. Unfortunately, because we all carry emotions, it does make it very difficult to create something that is 100% bias-free. Algorithms can absolutely eliminate a large chunk of bias for a private investor, but ultimately, whilst humans are involved, I believe that biases will continue to exist.
It’s not clear cut to me one way or the other. Potentially yes but they would need to be bias free. I think there is a place for both approaches but in this environment, only the best fundamental managers will survive. From now on, if you are going to be a successful active manager, you will have to be willing to embrace subjects such as behavioural finance when considering how to better your investment skills. There is still a place for the traditional fundamental managers, but they have work to do in terms of understanding the biases that are in their portfolio. Algorithmic trading might be a more foolproof way, long term, of generating returns but their biases need addressing too.
Some of the people I work with may have been managing money for 25 years and I say to them, ‘why don’t we have a chat about the behavioural biases in your portfolio?’ They can be quite guarded because there is an element of randomness in this profession when it comes to generating returns – skill of course, but luck plays a role too. No one wants to open up their history of returns and discover that the past 25 years have largely been down to luck. I have to be clear when I meet these portfolio managers that I’m there to make them better at what they do.
A portfolio manager will say that they run money according to a certain strategy, but over time, how they manage money may deviate from this approach. My job is to nudge them back onto their intended path.
Ultimately, if we can’t use behavioural finance to make us better investors, discussions of biases are just nice stories.
I think that if you are going to go down a traditional, fundamental approach and decide against using insights from subjects such as behavioural finance, you won’t last long. Understanding behavioural finance allows portfolio managers to plug spillages in their processes and over time, that can add up to a lot of additional alpha. The industry is under a lot of pressure at the moment and clients are demanding that active managers justify their fees.
When portfolio managers I have worked with start to publicise that they are starting to integrate behavioural finance into their investment process, it gains a lot of traction and support from clients. It’s a great subject from a client perspective because most will have heard about it and it is much easier to consume and understand than classical economic theory because we can resonate with the human behaviours. For example, you may go to a concert because you have bought the ticket even though you may not want to go on the day of the event. If the ticket was free, you might not go but because you have paid for it, you have an irrational desire to go. What we should focus on is the satisfaction of going versus not going, but we focus on instead is the historical cost which is irreversible.
That is challenging from a precision perspective as some of the biases are quite qualitative so it’s hard to assess the actual impact. One approach I take is to consider scenarios which estimate performance had a particular bias not been addressed. Quantitative biases such as the disposition effect are much easier to measure through historical trading patterns. Naturally, the impact of this will vary but on an annual basis, the leakage attributable to behavioural bias can typically be 40 to 160bps. I have also observed evidence from a behavioural finance fintech company suggesting that some of their clients now save up to 2% since their biases were highlighted. It varies from team to team but in its most extreme cases, it can be quite significant.
Just consider the disposition effect – over time the losses can really add up. Savings would have been made had the investor hit the button as soon as they thought that the investment thesis had changed for that particular stock.
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They could both be overconfident but for different reasons. The professional will know what he does and doesn’t like, have strong views on certain stocks and will generally read material that reinforces his view. Someone with no investment experience may have been reading tabloids and have the impression that the investing game always looked quite easy. The professional one would carry more investment specific biases but they will all have biases.
Most investors suffer from the disposition effect* – selling a stock too late, so the investor ends up selling when the stock is at rock bottom – a good solution for that is a stop-loss. Some professional investors use stop-loss strategies too. Losing money just resonates very poorly with almost everyone and we will go to great lengths to avoid it.
Investors need to regularly check whether or not their portfolio is behaving as they think it should be. If it is, then they should hold onto the assets, but if something has changed and the portfolio is performing quite differently to the anticipated behaviour, then that might be a signal to sell. An investor may realise that any underperforming capital would be better deployed, but take little action. Most would look at the low price of their stock and think ‘I’m not going to sell until it is back up to X again and break even.’ But the environment is probably different now to what it was six months ago.
‘Buy and Hold’ can be a sensible strategy, but if an investor does plan to hold onto their stock for 20 years, ideally they should limit how often they look at their portfolio. The more often they check their portfolio, the more often they are going to want to do something with it. That will turn an investor into a day-trader before they know it.
That is one of the risks that comes with all the technology on our phones; we are more connected to day-to-day movements in the portfolio and think we actually have to trade more frequently. An investor may pick up the paper, see that the price of gold is plummeting and think ‘I must review my gold exposure today’. Trading in and out of a pension is a costly process. An investor that decides to invest for 20-25 years will need to review their strategy, but not every day.
*Disposition effect: Reluctance to sell underperforming assets in the hope they will rise again or tendency to sell assets when they have increased, but could increase further. Often, the ‘losers’ plummet further and the ‘winners’ continue to rise; the investor has lost out in both instances.
Yes, of course, but I try to follow all the things I preach about and make it as process-driven as possible. When it comes to bias and having to make a difficult decision, relying on a robust process is the best thing to do. You can control processes but you can’t control outcomes.
A lot of people in this industry associate positive performance with good ideas or good process, and negative performance with a poor process or a poor idea, but I think that people should focus more on evaluating decisions at the time that that decision was made. I was in Asia at the beginning of the year and before I went out there I asked ‘what were your best and worst trades of 2016?’. They inevitably told me that their five best trades were the ones that made the most money, and the five worst ones were the ones that lost the most money. The point I was trying to make was that you shouldn’t evaluate the success of your decisions on simply whether or not you made money on that trade as that won’t teach you anything about your process. You should be working out whether the information you had at the time you made the decision and the process that you followed suggested you should make that trade. You may end up concluding that actually maybe it didn’t and maybe it was a bad idea. If you made money on it, that’s great, but it’s still something you may need to look at in future. If you conclude that at the time you made the decision everything looked great, but unfortunately, events happened after the execution that were out of your control, don’t beat yourself up about it even if you have made a loss.
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