Cutting Out a Layer of Bias

We all have flaws in our thinking that get in the way of making the best decisions. Even professionals.

It was my pleasure to hear Dr. Benjamin Kelly speak at today's CFA Society of St. Louis luncheon on the topic of Behavioral Finance in Investment Decision Making. Kelly, an investment strategist with BlackRock, is a charming fellow (despite being a Blackburn Rovers fan) with a knack for explaining Behavioral Finance.

The field has been around for a few decades - its earliest practitioners receiving the Nobel Prize in 2002. I'll dive a little deeper into some of the more relevant aspects in subsequent posts, but the gist is this: people are wired such that they do not always make the best decisions, especially when it comes to money.

The surprising part of today's talk (and others like it to CFA societies across the globe) is that it was being given to money professionals with the message that essentially says: you too.

This means that not only do investors have to overcome these detrimental biases, the next layer managing their money - the stock pickers, the active mutual fund managers - have to as well. And this is even before you factor in behavior caused by misaligned goals (poorly performing funds taking on huge risks to 'catch-up' by year-end, churning by brokers, etc.).

The easiest thing to do then to avoid multiplying the cognitive biases involved is to remove the opportunities for them to occur. Index funds instead of active management removes the opportunity for bias (and is a heck of a lot cheaper). Target asset allocation with rules for rebalancing avoids flawed subjectivity by swapping in objective boundaries. And avoidance of overconfidence leading to undue concentration of 'bets' on the market (or, God forbid, single stocks) can be had through diversification.

These are all 'unforced errors' that can be avoided once we are aware of them. The market will beat you enough days, don't beat yourself.