Thanks to the rise of behavioural finance, funds managers are generally aware of the innate human biases which influence decisions. Whether they can adjust for them is another question. Now, with economists involved in the study and measurement of happiness, the role of optimism is being analysed at both the organisational and individual level. STEPHEN SHORE investigates how managers can harness exuberance, without letting it overtake them.
Investors, along with the rest of the population, tend to be optimistic. After all, without a belief that things are likely to turn out good rather than bad, it doesn’t make much sense to enter the market – or to do anything for that matter. Optimism is a rational, healthy response to living in a world full of uncertainty. It has evolutionary advantages – for example, being more persistent in the face of adversity increases the chance of survival – and psychological studies have shown that optimistic people tend to be healthier, happier, and more resilient when bad things happen. Moreover, organisations are prone to cultivate optimism. Optimistic people are more likely to be hired, to generate enthusiasm, and to be motivated.
An optimistic attitude can even become a self-fulfilling prophecy. As Vince Lombardi, the legendary American football coach, famously said: “Winners never quit, and quitters never win.” Optimism untempered, however, can deviate from reality to the point of delusion. There are many situations – such as in funds management – where a realistic forecast will add infinitely more value than a belief that things will turn out for the best. Ignoring contrary evidence, overconfidence in one’s ability and the illusion of control can result in people being stubborn to the point of ruining a business. As E.L. Kersten, academic and founder of Despair Inc, a company which satirises corporate motivational attempts, not so famously said: “Quitters never win and winners never quit, but those who never win AND never quit are idiots.”
While optimism may not be something that people would want to eradicate from their organisation, some managers are taking active steps to limit its negative effects. With the growing popularity of the study of happiness, or wellbeing, and more scientific analysis of its part in economic as well as personal terms, it can now be shown that a pessimistic view of the future is likely to be closer to reality than an optimistic view. That is, if you take a pessimist and an optimist and get them to predict something measurable, the optimist will overshoot and the pessimist will undershoot. However, the pessimist will be closer to the mark. Should funds managers therefore hire more pessimistic analysts? Absolutely. Should they hire only pessimistic analysts? Absolutely not.
Optimism is not all good. But it’s not all bad either. Professional investors are confronted on a daily basis and are perhaps more acutely aware than most people that the world is uncertain. Jack Gray, strategist at the big quant manager GMO in Boston and Sydney, says: “You hear people say the markets are uncertain – they’ll wait until there’s more certainty. But it is intrinsic to capital markets that they are uncertain; if they weren’t uncertain you wouldn’t get higher returns. “[Uncertainty] is not going to fade and disappear at some stage, it’s intrinsic. In fact when it begins fade and disappear, as we’ve seen in the last five years with the great moderation where everything looked good, people take more risk and it leads to instability.
It is known as the instability of stability – it comes when everything has looked good and optimistic for too long.” Inalytics, a UK-based research consultancy, claims that the difference between outperforming and underperforming mangers resides not only in their skill, but in their susceptibility to behavioural biases such as optimism. Amanda Field, managing director at Inalytics in Australia, says that even underperforming managers have skill; it’s just that they succumb to behavioural traps to a larger degree than their more successful colleagues. In a study of 41 equity portfolio managers, Inalytics found that most managers had strong buying skills, adding an average of 47bps a year, but because of poor selling, the average portfolio was negatively impacted by an average of 94bps a year.
The firm reckons that because fund managers are typically optimistic, they have a tendency to focus on buying rather than selling. While it is true equities are more likely to rise in value than fall over the long term, by ignoring stocks that underperform, managers undermine the growth of their portfolios. Field says that to be a good seller, you have to be pessimistic. “Out of 300 portfolios we studied, only a handful of managers were good at both buying and selling,” she says. In a research report, Rick Di Mascio, chief executive officer at Inaytics, says good sellers are a rare breed, tending to be cynical and pessimistic. “They tend not to ‘fit’ [within organisations], but those with the ability to sell are highly valuable members of any investment team.”
The overabundance of optimism Daniel Kahneman, a psychologist who won the Nobel Prize for economics in 2002, says that people tend to be highly optimistic most of the time because of cognitive biases – errors in the way the mind processes information. Kahneman’s Prospect Theory offers an explanation for the phenomenon observed in the Inalytics research. His experiments have demonstrated that people tend to be concerned with the marginal impact of each investment decision, and feel the negative impact of a loss twice as much as the positive affect of a win.
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.
Some of these managers truly believe they have a gift or unique ability, and they are unaware of the enormous infrastructure that goes into doing things and supporting them.” The endowment effect is another well-known bias in the behavioural finance literature that says people tend to place more value on things they own, and confirmation bias leads people to ignore information that contradicts their convictions while overweighting information that supports them. Gray says he sees these errors in judgement all the time. “It’s not rational – but boy, you’ll do it. I’ve seen it on committees over and over again. Once someone goes into a deal and they start to get to know it and believe in it, their human capital is at stake. They’re not going to give up lightly, and they become overly optimistic. They need to be to keep pushing it through.” Industry structure bakes exuberance in People’s tendency to be optimistic is reinforced and even exacerbated by organisational structures.
Trying to counteract such biases is difficult because pessimism just isn’t popular. While pessimists may actually be more accurate in their assessments, no-one thinks an organisation full of them would be desirable. People don’t like it when you talk down the market, Ron Bird says. “People don’t want to hear those types of stories. Even if you convince them to accede that the market is overpriced, they still tell themselves ‘it’s not going to correct today’. “Psychologically, they want the good times to continue,” he says. “I have even experienced where a client sacked us simply because they did not like hearing our pessimistic views of markets.” Clients, indeed, also don’t want to hear their managers telling them that bad times are just around the corner – especially if it doesn’t happen straight away, and they underperform for a short period. Kahneman says that when pessimistic opinions are suppressed, while optimistic ones are rewarded, an organisation’s ability to think critically is undermined.
The optimistic biases of individual employees become mutually reinforcing and unrealistic views are validated by the group. Managers have to be optimistic about their ability to convince clients to allocate them money, Bird says. And they can do it because it’s very hard for a client to validate the likelihood of their claims – there’s too much randomness in the market. “It takes so long to establish whether the manager truly has any skill, that the clients can’t perceive it.” It takes a manager 80 years to prove itself – before it shows up in the numbers or past performance, he says. “This is a ‘trust-me’ industry – trust me, I’ve got skill.” GMO’s Gray says the industry doesn’t have much choice but to be generally optimistic. “For this industry it [being optimistic] is almost something you have to do,” he says. “The client wants to hear that you are confident, while they also know that you can’t be too confident. So the intelligent client is really gauging your calibration, between what you say you can deliver and what you actually can deliver.”
How managers are accounting for bias Managers aware of behavioural bias try to account for it in various ways. Some try to be objective by slicing their portfolio – prescribing a sell-by date for a particular stock that is adhered to regardless of market or manager sentiment. Others treat selling like buying – re-evaluating a stock by asking if it would be bought today if it was not already owned. If the answer is no, the decision is sell. But not everybody wants behavioural biases to disappear. While they cause some people to be overly optimistic and underperform, they also create the mispricings that allow other investors to take advantage and outperform. Exploiting optimism bias is about timing the correction, Bird says. “Shares are on average overpriced because of optimism, but knowing that alone doesn’t really help. Say that a share is 10 per cent overpriced because nine out of 10 managers are over-optimistic about its potential. Now, I’m the one out of 10 who thinks the market’s always overpriced, but if it stays overpriced that is no good to me.
I might know that this stock is 10 per cent overpriced; but that is of no use if it stays 10 per cent overpriced for the next 12 years.” Some managers adjust for this by adding at least a degree of momentum style to their investment philosophy. MIR, a quant-orientated manager which blends value and momentum, has an investment process based around trying to exploit mispricings caused by behavioural biases of other investors while attempting to guard against falling into such traps itself. From academic and in-house research, MIR says that when correcting, stock prices tend to under-react to individual information signals, but over-react to a series of like signals. Subject to confirmation bias, the lone pieces of information are ignored because they go against the manager’s conviction, but as such information becomes ubiquitous and the manager begins to change its mind, each additional piece of information confirms the new hypothesis. To time the change in sentiment that leads to a correction (or over-correction), MIR designed a quantitative process that delays investing in cheap stocks until they have demonstrated some improvement in momentum/sentiment, which suggests they are either in the early stages of, or about to enter, a recovery phase. In addition to the quantitative screen, MIR has an analyst evaluate the stocks selected from the screen to identify those for whom recovery is not imminent.
Contrary to most managers who identify stocks that are likely to succeed, this is a negative role which requires the analyst to be pessimistic about the outlook for stocks selected by the model. Such analysts will eliminate up to 20 per cent of the potential buy-list. Robert Wood, a professor at the Australian Graduate School of Management, says a well-known technique – that few people actually use – is to ask what the possible worst-case scenario is. “Once it has been identified, managers can ask themselves whether they can handle it. It may be difficult to go through this process, but by ignoring the potential pitfalls you may be unnecessarily exposing yourself,” he says. “The worst-case scenario might be that the management could leave, and there’s not much you can do about that. But you could look to see how locked in they are, and either change that or adjust your assessment of the risk accordingly.”
Kahneman says that mangers are likely to understate the probability of unfavourable outcomes. Even though any one of those outcomes might have only a small chance of occurring, in combination they may actually be far more likely to happen than the so-called ‘most likely’ scenario. GMO’s Gray says he knows of a number of successful firms that have hired a “designated bastard” to help out. A person that some organisations may have hired unwittingly, to the chagrin of their colleagues, this person’s main role is find fault with everything. He says: “We had a guy that came in to our Boston office that was quite young and inexperienced,” he says. “There was a model we used, a dividend discount model that had been built and added to over 20 years, and one of the senior partners in the firm saw it as his. This new guy actually stood up in many meetings and tore it to bits, pointed out all sorts of inadequacies and ways it could be done better.
It took an enormous amount of courage; either that or stupidity,” he says. “But the positive side was that it worked, we got a better model out of it. If it hadn’t been for this one guy, I’m not sure anyone else would have done it. I don’t think the industry is structured well enough to be able to take the opposite view and argue a case rationally and clearly.” Considering all the things that can go wrong, Gray says he doesn’t think that there is enough criticism in the funds management industry. “In the academic world if you give a talk, you stand up and say ‘my name is Jack Gray’ and you get 4000 objections.” Ray King, director of Sovereign Investment Research, says the role of ‘designated bastard’ may work best if it is rotated.
He also thinks too many bastards can be destructive. “They can wear down the person bringing the proposal, despite not having done much research themselves,” King says. Gray says if you challenge too much (and you can always challenge these things), it can undermine people. “If you undermine their core investment values you find people lose confidence and the last thing you want is a manager who doesn’t have confidence.” Do we need optimism? According to the Marriott School’s Steven Thorley, the aggregate of managers believing that they have more talent than is statistically possible is a necessary evil for a functioning market. In his book The Inefficient Market Argument for Passive Investing, he writes that if every manager was free from optimism bias and could objectively rate their skills against those of other managers, two-thirds would realise that they would be better off indexing.
If they were to leave active management, the skill-pool might improve, but that would only make exploiting inefficiencies more difficult. He uses the analogy of a basketball free throw game to illustrate his logic: If you were in the basketball free throw game, and were given the alternative to sit out and take the average score of the other players, what would you do? Your first thought might be to look around and make a guess at how your basketball skills compare to everyone else’s. If you think your skills are lower than average (and remember, that must be half of everyone) then the smart thing to do is to not play: to take the average. But what if everyone else takes this approach? Then only those in the top-half of the skill pool will choose to play, and the average score you get by sitting on the sidelines will be based on only the top-half players. From this more rational perspective, you should only choose to play if your skills are in the top quartile of all potential players.
But what if everyone takes this more rational perspective? Eventually no one but the very best player shoots, and everyone else gets his or her score. If everyone were perfectly rational, and not subject to overconfidence, there would be very few active investors. Thus overconfidence, perhaps the most pervasive of all investor irrationalities, is critical to market liquidity. “If active investing is a skill-based game, then the skilled players will be worse off when lower skilled investors choose not to play,” Thornley says. “As an active investor, your ability to outperform the indexing alternative (be better than average) depends on the participation of players with below average skills. Someone has to sell the stock you want to buy at a bargain, and buy the stock you want to unload at a higher than justified price. Someone has to be wrong in order for you to be right. If equity investing is a skill-based game, then active investors should be encouraged by the entry of new investors, particularly novices.”
If funds managers were realistic about their chance of adding value they might set up ‘Cynical Investment Management’, one former funds manager says, and just play the game to exploit the most fees out of clients. “Do you make money using the optimal strategy to maximise the returns for your clients?” he asks. “Probably not. The only time you need to have good performance is when you haven’t got any clients, and you want to get them.” All is not lost The view that optimism is good because it encourages low-skill investors to donate themselves as cannon fodder may be a cynical – or even pessimistic – view of the world. But the reality is that in every field of endeavour, the number of people who try will generally exceed the number that can possibly succeed. So why do all these losers keep playing? Tom Crvenkovic, a coaching psychologist, says that often the salience of the reward can outweigh the fact that the probability of it happening is infinitesimally small, and be sufficient motivation for people to pursue it anyway.
It depends on the person’s values, he says. For example, for someone who dreams of being rich, the salience of wealth may be more important than the possibility that a life without wealth might be squandered trying to achieve it. Or regarding a lottery ticket, the size of the prize and excitement of the possibility might make it worth the relatively small cost of the ticket and near zero probability of success for some people. Lotteries, it has been said, are a tax on people who can’t do mathematics. Also, if the likelihood of something occurring is rare we tend to attach more value to it. Thus things can be deemed worth pursuing simply because they are unlikely to happen, and enjoyed only by a few – such as winning gold at the Olympics. And sometimes people do defy the odds – even if it doesn’t happen as often as the swathe of rags-to-riches/ sporting hero’s stories and motivational literature might have us believe.
Producing a picture of pimply Bill Gates surrounded by a group of bushy haired hippies in 1978, Jack Gray says: “Do you think anyone but a pure optimist would have backed this kid when he said his aim was to have a personal computer in every home?” If everyone is realistic about the chance of success for a particular course of action, chances are no-one would ever do anything. Realism is not always the best alternative to optimism. “People can become so concerned trying to account for every unforeseeable difficulty that they suffer paralysis by analysis,” Crvenkovic says. According to Terrance Odean, professor of Banking and Finance at the Haas School of Business, moderately overconfident fund managers make decisions that are in the better interest of well-diversified shareholders than do rational managers, because they will be more comfortable taking on risk.
“In addition, overconfident managers benefit the firm by expending more effort than rational managers, as they overestimate the value of that effort,” he says. Crvenkovic says that cognitive bias doesn’t occur solely to lead us into error; it is a type of psychological armour. Just as attribution error can lead people to mistakenly take credit for positive things that occur, blaming external factors when negative things happen – rightly or wrongly –enables people to try and try again, ultimately increasing their chance of success. Tempered optimism So optimism is not bad, and funds managers, as Kahneman says, should not try to root it out of themselves or their organisations.
“Companies have to promote optimism to keep employees motivated and focussed,” he says. “At the same time, though, they have to generate realistic forecasts, especially when large amounts of money are at stake. Aggressive goals can motivate the troops and improve the chances of success, but outside-view forecasts should be used to decide whether or not to make the commitment in the first place.” According to Gray, you have to have a definite investment philosophy. You’ve got to really understand what it is you’re doing and why you have a chance of outperforming. “Once you have the core values based on realistic signals, then you need to be totally optimistic and believe in it – that’s the only way you’ll get through the tough times.
“Without core values, changing at every signal, you’ll end up churning your portfolio and underperforming.” While optimism my lead us into error, an objectively realistic outlook is probably not possible, nor even desirable. As the economist John Maynard Keynes once said: “If the animal spirits are dimmed and spontaneous optimism falters, leaving us to depend on nothing but mathematical expectations, enterprise will fade and die.”