Behavioural finance is what the marketing team has to think about when they communicate with members, or for the product team when they design products. It is what some fund managers speak about to explain irrational pricing. If this is how the CIO (chief investment officer) of a major super fund thinks about behavioural finance then they are correct. However, if that is where their thinking about behavioural finance stops, they would be missing some key insights from the field, some that relate directly to them and their roles, and that have material financial consequences. Two examples relate to group decisions (such as those made by major super funds’ investment committees or trustee boards) and the way super funds assess asset managers.
Group decision-making biases
Implicit in any decision-making structure that has at its apex an investment committee or a board, is that the group will come to a better decision than would individuals. However, social psychologists that have empirically tested the efficacy of decisions made in groups, have shown that this presumption is often false. In many circumstances, a range of psychological mechanisms result in teams arriving at decisions that are no better than individuals, and in some cases, are worse. These are decisions made by groups that are not randomly worse, but systematically, predictably biased away from optimal. Even more dangerously than merely biased, the evidence shows that in some circumstances groups can arrive at worse decisions that are actually made with greater confidence.
These effects are demonstrated by teams of investment professionals who participate in my workshops. For example, if group members have a subconscious bias before they enter a group decision-making task (which, through the design of my exercises is often deliberately the case), the bias is then also reflected in the group’s collective decision. Consistent with the empirical literature, decisions based on these group deliberations rarely do better than their average member and, rarer still, as good as their best member. When group decisions are important, these deviations from optimal can be costly.
Asset manager assessments
As well as their funds’ direct decision-making biases, CIOs should also contemplate how the asset managers they employ respond to behavioural finance’s challenges and opportunities. For example, do the asset managers think of behavioural finance in terms of vague concepts, or do they systematically identify and exploit the value of associated market anomalies? Do they consider behavioural finance insights when understanding the corporate financial decision-making of company CEOs and CFOs, and the associated impact on corporate governance, risk management and shareholder returns?
Super funds should also assess whether asset managers apply behavioural finance insights to themselves. Do they merely pay lip service to overcoming their own biases, or do they do something meaningful about it? Have they tailored their systems and processes, and do they foster a culture and mindset that is designed to overcome common decision-making biases? Do they measure and test for the presence of biases, taking an empirical approach to their own decision-making efficacy? Are there hallmarks of behavioural biases demonstrated in the transactions they choose and the frequency with which they trade? Do they demonstrate an awareness of behavioural biases in the way they communicate expectations for the future and in the way they navigate complexity and uncertainty?
Undertaking a high-level behavioural audit that incorporates these types of questions, can identify where potential blind spots lie and can open the door to exploring strategies that are designed to benefit funds in a number of ways: improved returns, reduce risk, or lower costs and taxes. Based on the empirical research, those who are not aware of these effects and do not have effective countermeasures against them, should be assumed to be making decisions that systematically deviate from optimal. These deviations ultimately translate into less desirable retirement outcomes for members.
As an industry, we are becoming accustomed to looking through a behavioural magnifying glass at members. If we want to achieve the best outcome for members, it’s time for the industry to apply the same lens to our own decisions and behaviours.
Simon Russell is director at Behavioural Finance Australia and the author of Applying Behavioural Finance in Australia.