There is a fine line between trend and truth in the market, thanks to prevalent cognitive biases that alter most finance professionals’ perception. However, advisers and investors who have the courage to bet against the tide are more likely to reap the rewards.
In the opening session for the Professional Planner Researcher Forum on Tuesday, Eric Marais, investment analyst at Orbis, said despite being some of the brightest minds in the world, most advisers and investors don’t actively challenge the so-called market truth they encounter, as it has become a natural part of their daily existence.
“There’s been some really interesting studies, for example, on how people who are extremely technically proficient but also have become overconfident in predictions, so it’s not always necessarily a good thing,” he told some 100 researchers, analysts and consultants in Double Bay, Sydney.
For example, those making decisions in a long economic cycle, biases that could be detrimental include the status quo bias (a false sense of comfort from the reality we’re experiencing), optimism bias (the belief that good times can keep rolling) and hot hand fallacy (the conviction that a string of successes can be maintained).
He said the hot hand fallacy is especially prominent when it comes to fund manager selections.
“We expect the winners will keep winning, but instead, we should expect that the tide will change,” he said.
“Don’t expect your winning managers to win indefinitely or to win consistently… and don’t fire managers that you trust and believe in following short term periods of underperformance like three or five years.”
Citing a study from Bayes and Cork University Business School, Marais said people who have passed the notoriously hard CFA exam are worse investors and had lower returns in the long term, despite admitting to being a charterholder himself. The issue that matters, he suggested, is not if one possesses relevant types of knowledge, but how they use it.
Marais said human brains are affected by cognitive biases that prohibit us from making rational decisions and incorporating new information in the way we should, and investors are no exception.
Retracing historical economic cycles, Marais highlighted that most investment professionals have likely lived through a limited investment scenario.
Assuming that one started working at the age of 23, those professionals under 65 have only really lived through a period of falling inflation and interest rates through an investing career; those under 56 haven’t seen an Australian recession; those under 44 have only seen technology being the leading stock consistently; and those under 40 have only seen growth stocks outperform value stocks, breaking a 200 year-long trend.
“What I think a lot of us miss is that the goal actually isn’t to not have bias, the goal is to reduce error to make less mistakes,” Marais said.
“Sometimes reducing bias works very well to reduce error, so I’m not saying that’s a bad idea. But sometimes it can be [an] even more effective way to introduce an opposing bias, something pointing to the other direction.”