Portfolio Manager Behavioural Biases

What is Narrative fallacy?

We naturally love stories and we sometimes let our preference for a good story cloud the facts and our ability to objectively assess a situation. The narrative fallacy leads us to see events as stories, with logical chains of cause and effect that are different from the real ones.

For investment professionals we expect them to have performed in the past. But, more importantly, to have a clear discipline to repeat this success in the future. Misunderstanding what happened in the past can prevent the portfolio manager from focusing on what really matters or can lead him to make the wrong decision.

How can we mitigate the effect of this natural bias?

Having a set of objective metrics and contrasting them to the portfolio manager narrative. A conscious effort should be made to isolate what can be attributed to luck and what is linked to skill or judgement. For all these reasons, conducting an investment skill analysis and comparing the objective metrics against the portfolio manager’s gut feelings should be a good starting point to mitigate the effect of Narrative Fallacy.

What is Loss aversion and the Disposition effect?

• Making the decision to invest into one strategy or another is less important than how we react to what has been achieved already
• The disposition effect refers to investors’ reluctance to sell assets that have lost value and the greater likelihood of selling assets that have made gains. This phenomenon can be explained by prospect theory (loss aversion), regret avoidance and mental accounting

How can we detect a disposition effect?

1. We look at the portfolio each day and identify the losing and winning trades
2. Then we look at how much of these winning or losing trades we are handling

What is PGR & PLR?

• PGR: is the proportion of gains realised. it reflects the  tendency to sell partially or totally winning position
• PLR: is the proportion of losses realised. It reflects the tendency to sell partially or totally losing position

What is Escalation of commitment?

• Escalation of commitment is a human behavior pattern in which a portfolio manager facing increasingly negative outcomes from investment, continues the behavior instead of altering course of his decision
• Escalation of commitment can lead to stubborn behaviour where the portfolio manager’s convictions become more ingrained in the beliefs he built on the world around him rather than what the external market signals will tell him

Why are biases neither inherently good nor bad?

For example having a momentum bias with some herding bias may be acceptable when we manage a growth oriented portfolio. However, biases can be detrimental if you are not aware of them and do not take action to keep them in check but they clearly come with upsides as well—they can improve decision-making efficiency.