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Keeping ourselves honest – A response to Joe Wiggins

Last month Joe Wiggins noted that fund managers frequently claim to make money by exploiting the ‘behavioural biases of other investors,’ but are often unable to explain how they avoid falling victim to these biases themselves.

Now it could be that ‘exploiting behavioural bias’ is simply shorthand for saying: ‘I believe that markets make errors’ and that, as long as you can identify the error, you don’t need to care too much about why it is created.

However, for the episode team, it has always been essential to acknowledge, and seek to guard against, our own behavioural biases. Below I have set out some of the ways we seek to do this, sticking closely to the framework suggested in Wiggins’ article.

It is clearly not the only way one can approach the issue, nor is it an exhaustive list, but it is the approach that has evolved for us over the course of more than two decades of thinking about the emotional element of investing.

Change your sense of risk

Perhaps the most important step is to fight the social dynamics that are often a powerful force in promoting emotion-driven investment decisions. Investors panic because we are conscious of what everyone else is doing, we fear missing out relative to others, and within the industry the temptation to ‘fail conventionally’ rather than take a contrarian stance is huge.

Our view is that avoiding the tendency to herd, or even going against it, in phases of market stress is often a source of opportunity.

Ensuring we can do this has involved ‘flipping the sense of risk.’ Within our team we have a shared philosophy that creates a predisposition to be contrarian in these emotionally challenging phases, and just as importantly, we articulate this clearly to clients.

It means that in phases where it is emotionally challenging to act, the thought process becomes less about: ‘how stupid am I going to look if this goes against me and I lose money’ and more about: ‘how am I going to look my colleagues in the eye, and how can I expect clients to stay with me, if I didn’t do what I have always said I would?’

Overconfidence? Acknowledge that you are human

The team element therefore becomes critical. While we want to avoid ‘groupthink’ with regards to idea creation or a lack of diversity in personality types, there is a key element that is held in common. That is a tendency toward honesty, self-reflection, and humility when it comes to our own ‘human-ness.’

Acknowledging that you are not resilient to behavioural forces on an emotional level is the first step to making sure that your decisions will be. Accepting that you are going to feel emotionally uncomfortable – and look foolish in front of others – the vast majority of the time is vital. Even better, you need to ‘enjoy’ the phases of greatest discomfort and take the emotional pain as an indicator that you have discovered a genuine investment opportunity.

Cognitive dissonance? Laugh at yourself

Wiggins suggests that one of the reasons managers (and humans in general) tend to believe they are less susceptible to bias than others is that it protects the ego against the dissonance between claiming to be an expert investor, yet also acknowledging that you have human flaws.

However, taking oneself too seriously can be a barrier to good decision making. To learn, we need to remember our mistakes. Many talk about keeping a record of trade decisions and rationales so that we can fight the tendency to reinvent the past. This is important, but – as many who took the CFA exam at the weekend may discover – being able to retain information over the long term often needs more than rote learning. Emotion plays a key role in driving our attention, and therefore what we learn, while stress can actively inhibit this process.

Acknowledging that we are human, with all the foolishness that comes with it, helps to guard against the overconfidence that can come with taking oneself to seriously. It is important to be able to distinguish between the seriousness of the job you are doing, and how seriously you take yourself.

It could be that the tradition of self-deprecating humour in the UK means that we are better than average at doing this. But we would say that wouldn’t we…

Too complex? Embrace ambiguity

The list of behavioural biases discovered by academia is apparently ever-growing, often contradictory, and increasingly under scrutiny.

Indeed even the very assumption that it is a natural human trait to think we are less biased than other people is in direct opposition to the growing focus upon ‘imposter syndrome.’ In fact, a paper in 2016 argued that the results of studies in psychology could themselves be skewed by the biases of researchers. The very complexity in identifying bias could be a barrier to taking steps to prevent them.

It is therefore very hard to make a case for establishing hard and fast rules to prevent us falling victim to any one bias. Neuroscience may offer more tools in the future, but at least for now we have to acknowledge that on this, as with so many other issues, we cannot delegate decision making to a series of static rules, and make peace with the fact that we cannot hide from tackling decisions on a case by case basis, with all the ambiguity that comes with it.

Personal narratives? Confront your memory

It is natural for human beings to reinvent the past to protect the ego; our tendency is to ignore the possibility that we have made a behavioural error. It is therefore essential to find ways to help keep our memories honest. As noted above, written rationales can be an important part of this, as can environment that destigmatises acceptance of behavioural influences.

The team element also becomes important again. A group of investors who can point out your own changing rationales and attitudes over time become a useful tool to guard against the tricks that our memories can play on us.

Conclusion

What all the elements above will have in common is a troubling lack of quantifiability. Almost by definition, the human need for comfort and certainty will tempt us to want to employ hard and fast rules, or quantitative strategies to try to remove the human element.

These can be useful, for example our team employ a valuation framework to avoid taking positions when the odds are not on our side. However over-reliance on such models can introduce dangerous rigidity, particularly in the face of structural change. A rigid valuation model, for example, could well have left many asset allocators meaningfully short of fixed income assets for much of the period after the crisis, and in Japan for even longer.

In our view, the reality is that, almost by definition, meeting the challenge of uncertainty in a dynamic world requires us to err more on the side of flexibility than dogmatism. This does not mean that we can absolve ourselves of a responsibility to articulate why we think that the inefficiencies that we seek to exploit are created, and how we protect against them. Instead it makes this articulation more important.

If you cannot do this, neither yourself nor potential investors have a framework for assessing whether your track record is luck or skill, or for establishing if your approach is ‘broken’ when the environment changes.


The value of investments will fluctuate, which will cause prices to fall as well as rise and you may not get back the original amount you invested. Past performance is not a guide to future performance.