Some investors have great analytical skills in assessing current and potential future investments, but the best investors also possess an uncanny ability to both recognize and combat their own behavioral tendencies when making investment decisions. This was the topic of Charles “Charlie” Bobrinskoy’s presentation to a packed room of eager members of CFA Society Chicago and local investment professionals at the Society’s Distinguished Speaker Series luncheon held on May 15, 2019. The program titled, “Combating Unhealthy Behavioral Tendencies in an Investment Firm” discussed how Bobrinskoy’s firm Ariel Investments has adjusted its investment process to incorporate the latest academic findings in the field of Behavioral Economics, and how these process improvements have helped Ariel’s flagship Mutual Fund, The Ariel Fund, become number #1 in its mid-cap value category over the last 10 years.
As way of background, Charles Bobrinskoy is the vice chairman and head of Investment Group for Ariel Investments. Headquartered in Chicago, the firm offers six mutual funds for individual investors and defined contribution plans as well as separately managed accounts for institutions and high net worth individuals. He manages their focused value strategy—an all-cap, concentrated portfolio of U.S. stocks. Bobrinskoy also spearheads Ariel’s thought leadership efforts and takes an active role in representing Ariel’s investment strategies with prospective investors, clients and major media. Additionally, he is a member of the Ariel Investments board of directors. Bobrinskoy is frequently quoted in various news publications such as The Wall Street Journal, Barron’s, Money and USA Today, is a regular contributor to CNBC, and is frequently a guest on Bloomberg Radio.
Many in the room with a CFA curriculum under their belts were familiar with the inherent behavioral biases in our decision making, but Brobinskoy started off by suggesting that he not only was going to share with us the most influential biases, but more importantly, he was going to teach us how to combat them. Some economists believe that no matter how much we recognize behavioral biases, we are helpless in trying to combat them. Bobrinskoy and Ariel Investments don’t believe this, and they have purposefully instituted structural processes to combat each bias.
Before jumping into each bias, there are four common observations in the markets that defy efficient markets. The existence of behavioral finance is why each of these market anomalies exist.
- Stocks beat bonds over the long term.
- Until the last 10 years, value has consistently outperformed growth.
- Small caps outperform large caps.
- And finally, there is momentum in every asset class.
Here is what we learned by bias, in no particular order.
- Confirmation bias. The tendency to seek data that is compatible with beliefs currently held and to reject conflicting data. Unfortunately, the smarter you are, the more susceptible you are to confirmation bias. A common example is people watch Fox News if they are a Republican and MSNBC if they are a Democrat.
Ways to combat: Appoint a fellow research analyst to play Devil’s Advocate. Challenging another analyst’s assumptions is inherently difficult because it creates conflict. Official appointment of a devil’s advocate actually removes the conflict inherent in challenging someone else’s assumptions because it is his/her job to contradict initial assumptions.
- Overconfidence bias. The tendency to overestimate what one knows and underestimate the uncertainties of the future.
Ways to combat: Place probabilities on outcomes, and ask for feedback on those probabilities. Ask questions to narrow down the range on probabilities.
- Anchoring on prior estimates. The tendency to adjust prior estimates insufficiently when presented with new information. This is why momentum exists in the markets.
Ways to combat: You need a culture that does not penalize analysts for revisions. Encourage analysts to change their views based on new information that is learned in the market.
- Loss Aversion. The tendency to overweight losses relative to gains. This is why there an equity premium. Investors are willing to accept a certain $5 gain, versus an expected return of $10.
Ways to combat: Ignore your costs basis. Examine each investment decision as if you didn’t own the stock. Ask yourself, “Would you buy it again today?”
- Endowment Effect. The tendency to overvalue that which one owns versus that which one doesn’t own.
Ways to combat: Keep a watch list of what you don’t own that is comparable to what you do own. Look at the data as if you didn’t have any portfolio positions in play and ask, “If I had fresh capital, what would I own today?”
- Reliance on Intuition over Data. The tendency to think one’s gut instinct is superior to data and to overestimate the significance of very small samples. Model based decisions are always better than guy instinct.
Ways to combat: Always trust the data over intuition. Ask yourself if a decision is data based or on gut instinct.
- Vividness/Recency effect. The tendency to measure frequency by one’s ability to think of example which in turn produces a tendency to overweight recent examples.
Ways to combat: Be required to have several examples to prove your point.
For further reading, Brobinskoy suggested three books:
- Thinking in Bets by Annie Duke.
- Thinking Fast and Slow by Daniel Kahneman
- Misbehaving: The Making of Behavioral Economics by Richard Thaler
Last but not least, if you’re a Republican, challenge yourself to watch MSNBC. If you’re a Democrat, challenge yourself to watch Fox News!