Behavioral Biases: What Is the Weakest Link in the Investment Profession?
Emotions are often seen as dangerous forms of weakness. Yet studies show that in everything we do, in life as well as in the investment profession, “thoughts, feelings, and actions . . . are inextricably linked at both the mental and biochemical levels”.
The mechanism of incentive and fear makes investing an inherently emotional process. The demands of specific investment decision-making roles can evoke differing emotions and behavioral biases in those involved. A sell-side analyst’s conflict-of-interest dilemma, for example, may require dealing with a qualitatively different set of behavioral pitfalls than that of a portfolio manager. Similarly, the behavioral biases that a sell-side analyst may often encounter — dissonance, for example — might be far removed from, say, the overconfidence that a portfolio manager may regularly confront.
How vulnerable are the various classes of investment decision makers to behavioral biases? Is there a difference in the degree to which they are susceptible?
To understand investor opinion on these questions, we administered a survey to readers of CFA Institute Financial NewsBrief to decipher which class of investment decision maker is the most vulnerable to behavioral biases. Though every role in the investment chain is prone to bias, the survey results indicate that those who more frequently encounter short-term pressures, such as retail investors reacting to market swings, are more susceptible than those who don’t interact as regularly with such phenomena.
Which class of investment decision makers is the most vulnerable to behavioral biases?
A decisive plurality (47%) of the 628 respondents said that no class of investment professionals is more or less vulnerable than any other. This response could be interpreted in two ways: Participants may simply be reflecting the actual reality. Or they may be displaying overconfidence or some other bias, having underestimated the susceptibility inherent in their particular roles and simultaneously overestimating it in those of others. The survey results tend to support the latter conclusion, as a 53% majority stated that different investment classes are prone to varying degrees of behavioral biases
One in five of the respondents — the second largest proportion — indicated that investment advisers are the most susceptible of four classes. It is true that in the investment chain investment advisors are the closest to the retail customer. There is also ample evidence that such customers, given their relative lack of experience, tend to exhibit more behavioral biases that could in turn evoke them in investment decision makers.
Sell-Side Research Analysts
Sell-side research analysts were selected by 16% of participants. Those on the sell-side can be pressured by their firm’s investment banking and brokerage divisions and often serve at least two masters: their investment banking and brokerage divisions as well as the investor clients who read their recommendations. Compared to other players in the investment chain, the sell-side analyst community could thus be more likely to succumb to behavioral biases like cognitive dissonance and herding.
Hedge Fund Managers
Hedge fund managers are the most vulnerable investment class according to 11% of respondents, the third largest cohort in this survey. Hedge funds service high-net-worth and institutional clients. Given the increased knowledge and experience levels of these customers relative to retail investors, it is plausible that hedge fund managers are less influenced by their behavioral biases.
With 6% of the vote, portfolio managers are the least prone to behavioral biases according to respondents. This is not so surprising given that, as a class, portfolio managers are likely to have the least amount of client contact.
So What Do We Do?
Everyone in the investment chain can be influenced by emotional and behavioral flaws. It is important, therefore, to be aware of the repeated behavioral pitfalls that we may encounter in our investment careers and devise control mechanisms to overcome them.
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All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer.