For example, when faced with the choice between a guaranteed profit of $300, or an 80 per cent chance of a $400 profit (and a 20 per cent chance of winning nothing) most people opt for the guaranteed $300 – even though probability suggests that taking the chance would be worthwhile – $400 x 0.8 = $320. Conversely, between a guaranteed loss of $300, or an 80 per cent chance of a $400 loss (and a 20 per cent chance of losing nothing) most people prefer to run the risk of losing the higher amount – the expected loss is $320 ($400 x 0.8 = 320). Investors are risk adverse when looking at profits but tend to be risk takers when confronted with losses. As a result, investors typically sell their winners to realise gains while holding onto losers to avoid crystallising a loss. But this is not the only error people make.

One of the most powerful biases is the tendency for people to exaggerate their own talents – believing they are above average in their endowment of positive traits and abilities, Kahneman says. A well-known example is that most people consider themselves to be an above average driver. A psychological experiment that found 80 per cent of people rate themselves as being in the top 30 per cent of drivers. If the experiment were turned on fund managers, the results would probably be even more dramatic. “Most fund managers believe they can add value for clients, but the majority of them are wrong,” Ron Bird, professor of finance at UTS and a former asset consultant and funds manager, says.

The performance of managers forms a skewed distribution, in which the majority will achieve a below average performance, yet almost every active manager is very optimistic about their ability to attain above average returns. When confronted with the statistical reality, all managers fervently believe that it is someone else who is mistakenly over-estimating their abilities. Steven Thorley, who is the H. Taylor Peery professor of financial services at the Marriott School, Brigham Young University, says that each individual investor should confront the question: ‘Am I in the top third of everyone who thinks they are?’ and the unavoidable answer – Probably not.

Moreover, people tend to misperceive the causes of certain events. Referred to by psychologists as attribution error, people take credit for positive outcomes while blaming external factors for negative outcomes. GMO’s Jack Gray, says that taking personal credit for lucky breaks and strong performance in a buoyant economy is probably the reason why there have been so many managers leaving institutions to set up boutiques lately. “One-third of managers have had substantial walk-outs this year,” he says. “It’s total over-confidence.” Gray says attribution error explains why so many mangers that are currently brimming with confidence are likely to encounter disappointment. “I remember an equity manager with a stunning track record who was pinched by one of the major investment banks that wasn’t particularly good with equities,” he says. “In his new role the manager turned out to be a disaster in performance terms, while the performance at his old firm continued to go straight up.