Biases

The first four biases looked at by Pompian are Overconfidence, Representativeness, Anchoring and Adjustment and Cognitive Dissonance.

Overconfidence

The most commonly sited behavioural bias associated with overconfidence is that clients show too much trading activity. This may be something that can be measured at individual firm level.

The study which he sites (which I have heard of the result but not yet read) is `Boys will be boys' which shows evidence of the overconfidence in males feeding through to excessive trading which leads to underperformance.

Representativeness 

This bias leads to people making judgements based on stereotypes... eg. assuming a fund will outperform because it has a certain style, and that type of style outperforms in certain circumstances. Another form that it shows up in is `The Law of Small numbers' otherwise known as the `Gambler's Fallacy'... where people assume a pattern from a very small selection. This could apply to the way funds are judged on short term performance rather than processes and philosophy.

Anchoring and Adjustment

People base their expectations on an anchor, so if a fund has performed in a certain way regularly, that is what they expect the next time. This could maybe apply to expectations of return where someone has lived through a high inflationary period, or a bull market.

Cognitive Dissonance

This is the most interesting bias. Pompian looks at the way we respond when our actions and our beliefs conflict. Do we change our actions, change our beliefs, or change our perception of our actions?

This starts to genuinely delve into the psychologist's space... The advice he gives when it becomes obvious that your response to this bias is negatively affecting you is...

`If you think you may have made a bad investment decision, analyze the decision; if your fears prove correct, confront the problem head-on and rectify the situation'

Decision Making for Investors

Michael.J.Mauboussin of Legg Mason provides some very useful insights and a whole lot of references to further read into in the paper, 'Decision Making for Investors'.

Unlike the believers in the efficient market hypothesis and advocates of index-linked investments, Mauboussin emphasises the need for a focus on process over short-term results in order to distinguish between luck and skill of investors.

He does believe that you can outperform arguing that 'super performers have more in common with one another that they do with the average participant in their own field.'

His paper approaches investor decision making from three angles:

1. Inputs from successful people in various domains.
2. Expected Value.
3. Heuristics and Biases and why we fail to calibrate probabilities and outcomes properly.

He highlights a further 3 strategies to avoid the problems:

1. Focus on process rather than the outcome.
2. A constant search for favourable odds.
3. An understanding of the role of time.

'Focus on establishing a superior process with the understanding that outcomes take care of themselves' - MJM

He quotes Robert Rubin:

Any individual decision can be badly thought through, and yet be successful, or exceedingly well thought through, but be unsuccessful, because of the recognised possibility of failure in fact occurs. But over time, more thoughtful decision-making can be encouraged by evaluating decisions on how well they were made rather than on outcome.

He quotes Nassim Taleb and discusses the asymmetric nature of stock market returns and the importance of fat tails. On the same subject he quotes Philip Anderson (Nobel Prize winning physicist):

Much of the real world is controlled as much by the "tails" of the distribution as by the averages: by the exceptional, not the mean; by the catastrophe, not the steady drip; by the very rich, not by the "middle class". We need to free ourselves from "average" thinking.

Finally he gives a number of challenges in order to overcome many of the problems he identified. These seem fairly generic and valuable not just in the sphere of making investment decisions. My challenge in the research I am doing will be to find tangible measures of how well we are doing at meeting these goals. Again, it seems though that these valid points all point to emotional intelligence, making a high quality decision and then the ability to 'just do nothing'. Here they are:

1. Try not to overestimate your abilities.
2. Actively challenge your own assumptions.
3. Ask disconfirming questions.
4. Realise that past events or prices are sign posts, not answers.
5. View decisions from various perspectives.
6. Seek information from a variety of sources.
7. Reframe questions.
8. Consider only future costs and benefits.

I would encourage the more eager readers to go to the original paper and then post any thoughts you might have on this paper in the comments section of this post.

Any other suggestions of other papers/books/articles to read would be appreciated.