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Are your cognitive biases preventing you from selecting the best investments for your clients?

By Kaavya Dijendranath

Updated on Friday, 18 May, 2018

The recent FE Invest Breakfast Briefing series explored the topic of cognitive & behavioural biases and their effect on investing. The speakers discussed the pitfalls faced by investors, advisers and fund managers alike and made it clear that none of us are immune from our own assumptions.

The Research team at FE, study funds thoroughly whilst conducting the required due diligence to include them in the FE Invest Approved list of funds and often bear witness to cognitive and emotional biases displayed by the fund managers. Charles Younes, Research Manager at FE highlighted the three most prevalent biases his team see in fund manager behaviour as confirmation bias, mental accounting bias and loss-aversion bias.

Confirmation bias: occurs when the market looks for or distorts new information to support an existing view. It often is due to overconfidence in personal beliefs and works to maintain or strengthen beliefs in the face of contrary evidence. This can lead fund managers to stick with declining stock far longer than they should because they interpret every bit of news about the company in a way that favours the company’s prospects.

This was evident in the case of JOHCM UK Opportunities. The data showed a structural decline in its performance - in FE’s meetings with the team we found a failure to assess the reality of the fund’s underperformance and address stock specific issues. Consequently, the fund was dropped from our FE Invest Approved List, the IA UK All Companies sector and saw £1bn outflows.

Mental accounting bias: occurs when people put their money into separate categories, separating them into different mental accounts, based on, say, the source of the money, or the purpose of the account. It leads portfolio managers to construct portfolios with arbitrary categories such as income, real assets and growth.

We believe the portfolio construction techniques used by Neil Woodford to run the Woodford Equity Income fund are not suited to the total return approach claimed by the manager. We have become concerned with the allocation to unquoted companies of which the only aim is to generate capital gains. The manager has actually split the portfolio into two separate buckets with the allocation to unquoted companies complementing the income-generating large cap portion of the portfolio. According to the attribution analysis we have run on Woodford’s track record at Invesco Perpetual, we also found little evidence that the capital gains made from the allocation to unquoted companies was significant, contrary to the gains made from the top ten holdings.

Loss-aversion bias: arises from feeling more pain in a loss than pleasure in an equal gain. Kahneman and Tversky found that humans feel the pain of a loss about twice as much as they feel the pleasure of the same sized gain. This refers to the tendency for people strongly to prefer avoiding losses than acquiring gains.

Loss-aversion bias was demonstrated by The Fidelity American Special Situation fund. The fund held on to Mattel stocks even after the shares took severe hits, ignoring all stop-loss calls.

At the advisory level

Advisers ought to be particularly vigilant to avoid the effects of these biases within a client’s portfolio. Adoption of a considered, consistent and disciplined investment process based on risk management and achieving the clients’ goals, can mitigate cognitive and loss-aversion biases. To overcome mental accounting bias – a total return approach should be used alongside strong portfolio construction skills.

Advisers who don’t have the time or confidence to manage and mitigate these behavioural risks are able to manage them by outsourcing their investment selection process to research partners and discretionary managers with specialist skills and resources to monitor and manage portfolios on a daily basis.

Eliminating biases - FE’s bias prevention strategy

FE’s inhouse bias prevention strategy begins with removing emotional attachment to fund selection decisions to create low- conviction portfolios that consider a range of scenarios for regular stress testing.

Data driven fund selection: Our process removes considerable emotional biases by delegating the decision making to robust data. The methodology uses FE’s ratings systems (FE Crown Fund Rating, FE Alpha Manager Ratings and Group Ratings) as the basis of any selection decisions, removing responsibility for investment selection from an individual. The analyst team subsequently validate this selection data and look for any gaps in coverage.

Low conviction approach:  Over 17 trillion combinations are run on these fund selections to identify  funds with highest diversification ratio for each portfolio. The portfolios focus on balancing risk in pursuit of consistent returns with managers who outperform in different market conditions with diverse expectations and strategies.

Scenario analysis:  The portfolios are stress tested under a number of worst case scenarios to ensure the efficacy of risk management. The house view believes that it’s impossible to call markets, but best to prepare for any/all worst-case eventualities.

It is worth mentioning here that no process is completely bias free. We aim to evaluate outcomes constantly to understand drivers to ensure that we are constantly improving.
‘’Don’t fall in love with the process – it’s broken, you just don’t know how yet’’ – Rob Gleeson, Head of Research, FE.

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