The hidden psychology behind investment decisions

In my last blog I wrote about the behavioural biases that can distort investor thinking, and today I’ll share more of my experiences of this phenomenon, including how it can affect fund managers.

Let’s start with a simple question: would you want to be operated on by a brain surgeon who got it right 60% of the time? I’m going to assume not. Yet a fund manager who gets it right 60% of the time would be perceived as a hero – that’s just the nature of their industry.

What intrigues me, though, is that despite widespread understanding of this dynamic, a fund manager with a good short-term track record will have little trouble keeping an audience engaged, yet a manager with poor short-term performance is often met with less enthusiasm.

The halo effect

The fund manager enjoying a period of strong performance can bask in the ‘halo effect’, whereby one trait (in this case their recent career success) leads others to have a positive impression of the individual overall.

Conversely, the ‘horn effect’ weighs on the fund manager suffering a spell of underperformance, often meaning the sales rep must use their skill to build a genuine connection to create a more positive impression.

I’ve learnt that the best presenters don’t always make the best fund managers, and I’m pleased to note that many of my clients reach the same conclusion. Nonetheless an ability to present investment ideas is clearly an important skill for fund managers. While not strictly a behavioural bias, the ‘peak end rule’, which suggests that people tend to judge an experience by how they felt at its peak or end rather than the sum total, offers a useful psychological insight for any fund manager working on their pitch technique.

Status quo bias

Stock selection in a fund is also fraught with behavioural bias. For example, selling a stock for a gain is associated with positive emotions, while selling for a loss is associated with negative emotions. This can lead to ‘status quo bias’.

You’ve probably heard that if you put a frog in a pot of water and gradually increase the water’s temperature until it boils the frog won’t jump out. Although this isn’t quite true, fund managers can sometimes illustrate the metaphor, doing nothing even though maintaining the status quo isn’t the best course of action.

The theory of ‘regret aversion’ is also relevant here, as it offers an explanation for the tendency of investors to refuse to accept bad decision making, potentially leading them to delay selling a losing stock or moving to cash.

Misplaced confidence

Moving from behavioural biases specifically to other psychological biases that can affect the sell side, overconfidence surely deserves a mention. I kid you not that both fund managers and my sales peers have already started talking about year-to-date performance, just two months into 2023!

It can be difficult to persuade someone to question a deeply held belief, even if that belief is the result of overconfidence.

I’ve learnt that if I present facts that contradict someone’s belief in a meeting, more often than not it’ll backfire, and they will become even more convinced they are right. Instead, it’s often better to ask them to explain their reasoning.

Putting past performance in its place

We often use performance as a tool, albeit a potential investor is only concerned about how a fund will fare once they are invested. Positive past performance appears to offer validation, and can create a bandwagon effect, leading to large inflows – it’s instinctive to look at something that is popular.

A client recently informed me that they removed the performance metric from funds they’re considering, as they want to understand how the fund is constructed to create a suite of funds that work in different markets. That was a refreshing – if rare – conversation.

The brain is very complex but can be broken down into two parts: the sub-conscious element, which is automatic, and can be emotional, and the lesser-used rational part. They are both intertwined, but more often than not the former dominates the latter.

However, as the above conversation with a client illustrates, it is possible to make conscious decisions to combat emotional decision making in favour of rational analysis.