There’s a natural tendency for financial markets to consistently become more sophisticated. Investors’ understanding of how markets are integrated and interrelated, including analytical frameworks for pricing various instruments, also tend to follow this evolutionary path. Investment practitioners and academics have pushed the boundaries of modern finance theory to include various other disciplines in an attempt to know the unknowns. These dynamics have resulted in several new tools and techniques used by many investment professionals.

In particular, psychological and physiological factors that affect the decision-making process have gained a lot of attention. The widespread development and acceptance of behavioural finance, with all its empirical evidence, have raised awareness of the fundamental thought processes that influence investors’ decisions and how these can be optimized. As a result, topics such as cognitive biases and mindfulness meditation are gaining more traction.

One of CFA Society Toronto’s events last year—Blind Spots: The Psychology of Effective Decision Making—focused on cognitive biases. Led by Craig Dowden, Ph.D., a renowned business psychologist and speaker, the interactive presentation delved into the many biases that, consciously or unconsciously, block us from making optimal decisions.

Take self-serving bias, for instance. Dowden cited a survey indicating that people have confidence in their own decisions 83 percent of the time, but their confidence level drops to 23 percent when these decisions are made by someone else. Some of the other biases that could cloud our judgment include the tendency of people to conform to others when making their own decisions and to succumb to time pressures.

Each of these biases makes a good recipe for bad decisions, and Dowden provided important insights on how to overcome these barriers. “Each of us has the capacity to act unethically and make bad decisions,” he explained. “Being aware of our possible biases and triggers equips us to minimize [the likelihood of] this…happening.”

As with bad habits, acknowledging the existence of these biases is a key step in removing them. The main theme of the presentation was that, regardless of the amount of information at our disposal, our emotions usually trump logic when we respond to situations.

“The investor’s chief problem – and even his worst enemy – is likely to be himself.”
– Benjamin Graham

The key lessons from this presentation are timeless and apply to everyone, both in our personal and in our professional lives. Investment professionals can benefit from these ideas, given the high-pressure, dynamic environments we work in, where every decision we make has a direct monetary impact. It has been empirically proven that investment performance can improve simply by controlling behavioural factors when making investment decisions. A recent JPMorgan Chase study showed that, for a standard indexed portfolio with 60 percent in the S&P 500 Index and 40 percent in bonds, the 20-year annualized return was 8.7 percent. The average investor, on the other hand, earned only 2.5 percent during the same period.

This whopping difference has been famously named “The Behavior Gap” by Carl Richards, a well-known columnist for The New York Times.

The Behavior Gap is essentially the deviation between how the market performs relative to what investors actually earn as they succumb to their emotional impulses and diverge from their long-term plans. Richards goes as far as to claim that investors can wipe out their entire lifetime’s return with one behavioural mistake. Interestingly, he claims investors can outperform 99 percent of their neighbours just by owning an average mutual fund and behaving correctly.

The Behavior Gap is just one example. There’s a wealth of literature in the areas of behavioural finance and economics that point to the importance of human behaviour, given its inherent irrationality and volatile nature. In that respect, Dowden’s presentation represents only the tip of the iceberg for those interested in digging deeper and with a genuine interest in improving their decision-making abilities.

To a certain extent, these findings should provide some comfort in a world where information is generated, disseminated, and consumed at lightning speeds. The volume and velocity of this information requires, more than anything, improved robustness in our decision-making processes, which leads us to understand and overcome our own cognitive biases. The result is more favourable outcomes.

In essence, better decisions require a shift of focus back to fundamentals in response to the ever-increasing sophistication of markets. Regardless of the complexity of the decisions we’re required to make, the legendary Benjamin Graham said it best: “The investor’s chief problem—and even his worst enemy—is likely to be himself.”