Behavioral finance has legitimately called into question the unrealistic assumptions that conventional economics makes about human behavior. It has shown that we are not “rational” but suffer from such behavioral biases as loss-aversion, representativeness, hindsight, anchoring, confirmation, mental accounting, and more.
But does behavioral finance go beyond exposing the weaknesses of conventional economic thinking and offer solutions? For instance, does it provide tools that professional investors can employ to overcome behavioral biases like groupthink or conformity?
The answer, according to behavioral finance coach Paul Craven, ASIP, is yes. Craven explained that groupthink has been a well-documented human bias for some time. He referred to the conformity experiments conducted by researcher Solomon Asch in the 1950s that demonstrated the high degree to which an individual’s own opinions are influenced by those of the majority in a group. Members of an investment committee might suffer from the same tendency and be eager to agree and reluctant to disagree, even when they have ample reason to.
I asked Craven what can be done to address the problem of groupthink in the investment committee context. He said that the chair of the committee has a key role to play in tackling the issue. The chair can create an environment where people are not dissuaded from voicing dissent and are encouraged to play the devil’s advocate.
But isn’t playing the contrarian difficult in practice? After all, by disagreeing, you could be seen as disagreeable. Craven thinks that an investment committee can be smart and formal about how it uses a devil’s advocate. A member of the committee could be assigned the task of researching an issue and coming in prepared to argue the other side of what is being proposed. Craven gave the example of 12 Angry Men, a classic drama, in which one dissenting member of a 12-man jury successfully plays the devil’s advocate, resisting and challenging the consensus of his 11 colleagues until they are all won over.
In addition, Craven clarified, we can all play the devil’s advocate in our own minds, questioning our views and arguments, rather than assuming our reasoning is always sounds. To paraphrase John Maynard Keynes, we should be willing to change our minds when the facts change.
A related measure, said Craven, is keeping a journal of key decisions and recording the rationales behind them instead of relying on memory. A recorded journal allows you to revisit your reasoning on a particular investment decision and will keep you from forgetting and rewriting the past in your mind as time progresses. “Memory is a very bad teacher,” cautioned Craven, and you may not be able to accurately recall why you made a certain decision at a certain time. By going back to the recorded logic behind the decision, an investment committee can judge if it was suffering from groupthink or demonstrated an openness to alternative views.
As Craven put it, these three measures — creating an environment where people can disagree, ensuring the devil’s advocate role is an integral part of the decision-making process, and recording the rationale behind decisions once they are made — are about self-awareness and self-discipline. And that’s what it takes to manage behavioral biases in investment decisions.
All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer.
© 2015 CFA Institute. First appeared in Inside Investing http://blogs.cfainstitute.org/insideinvesting/