Impotence of Belief in Bias
A new study from Leibniz University Hannover finds that the 1/3 of German professional fund managers who believe human biases to be important in financial markets have better calibrated estimates and rely more on momentum and contrarian strategies, but otherwise think and act like other fund managers:
[A] literature in psychology … has clearly revealed the "bias blind spot" (Pronin et al., 2002), i.e. the belief that one’s own judgments are less susceptible to biases than the judgments of others. … [Among] professional … fund managers we differentiate … "endorsers" of behavioral finance … [who] believe that the approach of behavioral finance truly reflects decision behavior in fund management (and who know the key messages of behavioral finance well) … [and] non-endorsers. … We have surveyed [104] fund managers in Germany and classify them according to their self-assessment into these two groups. …
Whereas [the 37] endorsers recognize significantly stronger behavioral finance effects in other fund managers’ behavior than non-endorsers, the perception of their own behavior is largely unaffected by their insights. When endorsers’ are asked about their own behavior with respect to items being linked to behavioral finance, such as hindsight bias or disposition effect, they answer as non-endorsers do. However, there is one exception … Endorsers show less miscalibration with respect to forecasting the interval of a stock index. … We [also] find … endorsers rely more on momentum and contrarian [versus buy-and-hold] strategies. … Endorsement … is not closely related to personal characteristics, such as being older or holding a better position etc.
Even for those with strong incentives to correct for biases, knowing about and believing in biases has influenced their decisions little, and not obviously to their benefit. This suggests that we focus not on trying to correct our personal biases but instead on identifying and promoting institutions, such as prediction markets, to reduce biases.
Hat tip to Zubin Jelveh and Tyler Cowen.
I'm a little confused by this study. Lets go down the list of questions in Table 5. Assessment of one's own behavior:
[6] Hindsight Bias "The majority of economic news is not surprising to me". Is this testing hindsight bias at all? It seems to me that this is testing the difference in how endorsers and non-endorsers define surprise. This question leaves me wondering if respondents' answers imply they believe they were able to predict events. I think a better question would have been "Were you expecting (Big Recent Economic Event X) to happen?"
[7] Better Than Average "How do you evaluate your own performance relative to other asset managers." The author of this question is ignoring survivorship bias. I would imagine that every fund manager working today thinks they are better than average based simply on the fact that they are simply in business. When fund managers look around, they see the competition failing all the time. The average life expectancy of asset management groups is notoriously short. Give them some credit.
[8] Miscalibration "DAX 90% confidence interval for next month" This is the only question that directly measures an asset managers ability to benefit from lower biases. This is also the only question that proved statistically relevant. It indicates that endorsers might have a better understanding of volatility, risk, or their own lack of ability to predict near-random variables.
[9] Disposition Effect "I prefer to take profits when I am confronted with unexpected liquidity demands." Compare this question to note 7 "If the investor is faced with a liquidity demand, and has no new information about either stock, she is more likely to sell the stock that is up." I think a question phrased off note 7 would have been more effective.
[10] Home Bias "Allocate a portfolio" This seems to target the home bias well, but I probably still would have explicitly stated that the fund managers will not be able to reallocate funds for 20 years so that they know their familiarity with the German market won't help the portion allocated to Germany.
I would also have liked to see what kind of performance these funds have exhibited over the last 5-10 years. I think historic performance would be a much better indication of how much an understanding of biases is effecting a fund managers ability to make decisions.
Overconfidence bias is one of the most common and universal. One manifestation is that people choose too small a range when expressing uncertainty about some value. They undervalue the probability of values outside that range. Applied to markets, one might expect that this bias would lead traders to undervalue the probability of extreme market moves which take prices outside of a given trading range.
Yet from what I understand, this does not happen. Indeed, if it did, it would lead to an extremely easy money-making strategy; simply buy options and other instruments which will profit on extreme moves. If market prices undervalued these instruments then it would be an easy and obviously profitable investment. But markets move to nullify easy and obviously profitable investments, because investors will buy them and drive up the prices until they are no longer automatically profitable. This is one example of a way in which the cognitive biases of individual traders get nullified by market mechanisms.
The interesting thing is that this can seemingly happen in two ways in terms of individual overconfidence. One way is that some traders may happen to differ in opinion from the market as a whole, and overconfidently think the price will move substantially higher or lower than current prices. They will buy up these out of the money instruments until the profit opportunity disappears. This behavior is consistent with individual overconfidence bias.
The other possibility is for people who personally are inclined to overconfidence to be forced to confront their bias in the face of (let us suppose) a historical record of the market undervaluing extreme moves. They take positions which contradict their intuitive but biased beliefs, driven by the plain fact of an exploitable profit opportunity. With money on the line, greed and fear trump bias, and perhaps they are even led to change their beliefs and reduce their bias, accepting that prices may indeed move much more than seems intuitively plausible.
I wonder which factor dominates. The first doesn't seem strong enough to explain rational market pricing, while the second would predict that traders, especially successful ones, would be less biased about factors relating to their investments than non-traders. I would say anecdotally that most traders I have spoken with seem to me to be quite overconfident and biased about their investments, but perhaps that is just posturing and their internal beliefs are more moderate.