Overcoming Behavioral Biases:
The Importance of Our Proprietary
Portfolio Exercises
EQUITY | MACRO INSIGHT | OCTOBER 2022
All humans have behavioral biases, those blind spots that AUTHORS
can impact decision-making. Some people are overconfident
about their abilities; others attribute too much value to
things in their possession; some unwittingly attach too
much importance to things that are not important at all. EDWARD J. PERKIN, CFA
Chief Investment Officer,
Much has been written on the subject of behavioral Eaton Vance Equity
biases. Daniel Kahneman won a Nobel Prize in Economics
on behavioral economics, the only economics winner who
was not an economist (he holds a Ph.D. in psychology).
Research has shown that behavioral biases can impact
decision-making in a number of fields: judges are inclined AARON DUNN, CFA
to be more severe before eating lunch, more lenient Co-Head of Value Equity
after; doctors have been known to make mistakes based
on assumptions about what they have seen in the past,
overlooking new data at their fingertips.1
Behavioral biases exist when human beings fail to act CHRISTOPHER DYER, CFA
“rationally” and process all the information available to Head of Global Equity
them when making decisions. As investment managers,
we must recognize that individually, and as an investment
team, we are likely to have biases about our stock selection
process, the sizing of positions, portfolio construction,
even risk management. Understanding that we have these
biases is the first step, but what can we do to proactively
overcome them? The Eaton Vance Equity Group believes
that having deep company-specific knowledge, training
in financial statement analysis, and decades of collective
experience are necessary, but insufficient, to achieve
strong investment results. Since 2014, we have integrated
the discipline of conducting Portfolio Exercises into our
investment process, a differentiator in the way we manage
money and an important element to our success.
1
Diagnostic Errors in Medicine, Mark Garber, February 2007
MACRO INSIGHT
Behavioral Biases and Their Impact on “There are over 150 documented
Investing
We have learned that human beings are not always “rational”
behavioral biases that can impact
and don’t process all the information available to them when decision-making in life—and in the
making decisions. There are over 150 documented behavioral
biases that can impact decision-making in life—and in the investing world.”
investing world. Here is a sample.
LOSS AVERSION
OVERCONFIDENCE BIAS
People don’t like to lose, and loss aversion is the tendency
People are overconfident about many things: their ability to
of people to prefer avoiding losses, as opposed to acquiring
drive well, their sense of humor, and their certainty that “they
equivalent gains. Kahneman’s research suggested that losses
are absolutely right” about specific things. Overconfidence
are psychologically twice as powerful as gains, in the sense
bias is defined as a tendency to have a misleading assessment
that someone who loses $100 will feel twice the pain versus the
of ourselves, a belief wrapped in ego that we’re better than we
satisfaction of gaining $100, i.e. a person would have to gain
actually are.
$200 for their feelings to equalize.3
Overconfidence in investing can be detrimental. While we want
In the case of investing, individuals and investment teams may
our professionals to be confident, we find that overconfidence
stubbornly hold onto investments, in the face of obvious reasons
tends to be a weakness. Money managers have to understand
to sell. The thought is that one doesn’t lose money if one doesn’t
that sometimes they will be wrong about their assumptions and
sell, a behavior that is not necessarily rational when processing
projections—and ultimately the stocks they pick. In one survey,
all the available information.
74% of fund managers responded they believe they were “above
average” at investing, the remaining 26% thought they were
average.2 Of course, no one thought they were below average, a
statistical impossibility, but not at all surprising.
2
“Behaving Badly,” James Montier, 2006
3
Prospect Theory, Daniel Kahneman and Amos Tversky, 1981
2 MORGAN STANLEY INVESTMENT MANAGEMENT
OVERCOMING BEHAVIORAL BIASES: THE IMPORTANCE OF OUR PROPRIETARY PORTFOLIO EXERCISES
RECENCY BIAS
Studies have shown that people are prone to make decisions
based on recent events. A lawyer’s closing argument might have
much more weight than evidence offered earlier in the week.
Employee evaluations are sometimes based on the past month’s
work, as opposed to the full year.
In investing, recent events in markets sometimes hold more
weight than a longer-term view. It is not uncommon for
individual investors to buy near the top during market run-
ups and sell at the bottom during downturns. In money
management there are reams of data that need to be parsed
when making investment decisions—some short-term, some
longer-term. Many money managers talk about the need to
“tune out the short-term noise,” but that’s often easier said
than done.
ANCHORING
People often become fixated on an “anchor” which can
irrationally impact their decision-making. In a famous study,
people were asked to take the last three digits of their phone
number and add 400, and then asked the year Attila the Hun
was defeated (which few know, which was the point). Their
answers formed a perfect regression despite the fact that the Investors should realize that just because they own a particular
phone number plus 400 had absolutely nothing to do with investment, regardless for how long, it doesn’t necessarily mean
Attila. The fabricated number had become an irrational anchor.4 it is more valuable than other alternatives in the market.
There are many real-life anchors in the world of investing. HERDING/GROUPTHINK
Individual investors create anchors about their investment Herding is when people follow the crowd instead of their own
expectations based on news (“Gold nearing its YTD high”) or instincts and/or analysis. In a well-known study, participants
talking to colleagues (“I’ve doubled by money on crypto”). For were asked to answer a question by a show of hands (so
investment managers, anchors could be the price you paid for a that everyone in the group could see how everyone else was
stock, its 52-week high or a recent earnings estimate, and while answering). In the first part of the test, the answer was obvious
it’s important to analyze these data points, managers shouldn’t and everyone got it right. But in the second part, there were
let their decisions get weighed down by them. “plants” in the group who intentionally answered incorrectly—
and guess what? Many more participants got the answer wrong,
ENDOWMENT EFFECT a classic example of herding, where people might be lazy,
The endowment effect refers to the fact that people will place indifferent or question their own judgment.5
a higher value on something they own than on an identical
good they do not. This bias can influence a fan with a concert We do not think it is a good idea for investors to follow the
ticket or a CEO selling a company, both of whom perceive their crowd, i.e., the markets or other investors. Economist John
item is more valuable than what the market might indicate, Maynard Keynes once said, “Worldly wisdom teaches that it
just because they own it. Mere possession of an asset can impair is better for reputation to fail conventionally than to succeed
rational decision-making. unconventionally.” To achieve success in investing, we believe it
is critical for people to think for themselves.
4
Russo and Schoemaker, 1989
5
Asch Conformity Study, Solomon Asch, 1951
MORGAN STANLEY INVESTMENT MANAGEMENT 3
MACRO INSIGHT
been heard. Other valuable tools include giving individuals
the “cover of anonymity” by using blind votes and anonymous
submissions in order to invite dissent rather than conformity.
“Debate and disagreement are
hallmarks of effective working
groups and while a hiring manager
might seek employees who are ‘just
like me,’ this can result in a lack of
cognitive diversity and pressure
to ‘go along to get along,’ features
that are not conducive to good
decision-making.”
Eaton Vance Equity –
Proprietary Portfolio Exercises
Building and Leading an Effective
Within Eaton Vance Equity, our investment teams study
Investment Team behavioral biases and how they might impact investment
Certain behavioral biases affect us as individuals, while others decisions. More specifically, we have developed and use over
are more prominent in group settings. One way to guard 30 proprietary Portfolio Exercises that are designed to help
against groupthink and conformity is to be thoughtful about portfolio managers and analysts systematically recognize—and
the design and management of an investment team. Debate and overcome—their personal investment biases. In essence, we are
disagreement are hallmarks of effective working groups and trying to define the problem, the biases, and develop a solution,
while a hiring manager might seek employees who are “just like the Portfolio Exercises. These exercises are an integral part of
me,” this can result in a lack of cognitive diversity and pressure our investment processes, and are performed by our investment
to “go along to get along,” features that are not conducive to teams on a regular basis to help us overcome biases.
good decision-making.
“TWO MISTAKES I MADE LAST YEAR”
An alternative approach is one in which the team leader
identifies a list of must-have attributes, such as curiosity, At some point early in the year, we ask everyone on the team to
independence of thought, intelligence, honesty, and a strong think about two mistakes they made over the past 12 months. For
work ethic. On top of that foundation, team members should example, “the stock price hit my target, but I talked myself into
have diverse skill sets and backgrounds. One person might be holding on just a little bit longer” or “the CFO abruptly left the
especially strong at accounting, another at reading people. One company, which I know is a red flag, but I dismissed it, and they
might be eloquent, another shy. One might be from an Ivy subsequently had to restate their financial statements.” Everyone in
League business school, another from the school of hard knocks. the group then presents their “mistakes” to the rest of the group.
Once the team is built, the leader should be careful to conduct There are a couple of important reasons why we do this. One goal
group and one-on-one interactions in a way that minimizes the is to engender the continuous improvement of our processes by
pressure to conform or shut down debate. Techniques for doing having people learn from their own and their colleagues’ mistakes.
this include regularly reiterating the expectation that respectful Another is to wipe the slate clean for those coming off of a difficult
disagreement is encouraged from each member of the team; the year so they are not hampered by the baggage of history. Likewise,
leader admitting to mistakes in front of the group; the leader it brings a dose of humility to those who need it.
resisting the urge to tell others what they think of an investment
The behavioral bias we hope to address is overconfidence. As we
idea before the discussion is completed and arguments have
see it, good money managers are confident, not arrogant.
4 MORGAN STANLEY INVESTMENT MANAGEMENT
OVERCOMING BEHAVIORAL BIASES: THE IMPORTANCE OF OUR PROPRIETARY PORTFOLIO EXERCISES
“ONE UP, ONE OUT”
“We have developed and use over
The assignment is for everyone on the team to review the
portfolio and pick one stock outside of their own area of direct 30 proprietary Portfolio Exercises
responsibility where they would add more to the position, another
that they would liquidate entirely. The intention of the exercise that are designed to help portfolio
is to give every member of the team “a voice” in management
of the portfolio, obligating them to take a “holistic view” of the
managers and analysts systematically
portfolio beyond their individual areas of coverage. recognize—and overcome—their
We believe the exercise addresses loss aversion, in the sense that personal investment biases.”
team members have to get rid of something, even if it is showing
a loss at the time. It is also designed to hold sector-specific
analysts accountable for “the whole portfolio experience” in “DESIGNATED BEAR”
order to align them with our clients. We believe counterargument can be the linchpin of good
investment decisions. Whereas everyone on the team might
“ROBINSON CRUSOE” feel great about a certain investment thesis, a well-researched
Robinson Crusoe was a castaway who spent 28 years on a counterargument might uncover something the team is missing.
remote desert island. In this exercise, we ask investment team In this exercise, we ask an analyst to present the case for owning
members to imagine being stranded on a desert island for five a particular stock in a sector they cover, then name a Designated
years, without access to information or the ability to trade. Bear to present the case for NOT owning the stock. The exercise
Then, as Robinson Crusoe, identify the ONE stock you would is borrowed from the military (red team/blue team) and sports
want to own for those five years. (scout team), where it can be helpful to seek out the perspective of
your adversary.
The goal here is for team members to overcome any recency bias
(or short-termism) they might be experiencing. For example, We prefer volunteers in this exercise because research shows
we do not want team members to be obsessed with the current the best results occur when the Bear fully believes in what
market environment or to hold out for the perfect entry-point they are presenting, rather than going through the motions
price when buying a stock in a great long-term business. We of acting out the contra case. The goal of the exercise is
keep a running list of stocks identified in the exercise, so that designed to systematically break down any herd mentality, and
when the market drops dramatically (as it has this year), we are complacency, that might have infected the group.
ready to act.
In summary
“TIME-TRAVELING REPORTER” Behavioral biases are well-documented phenomena that
This is another exercise designed to help overcome recency bias. are nonetheless quite prevalent in the investment world.
Each team member is asked to think of themself as a financial Overconfidence, herding, loss aversion, anchoring, recency
journalist with access to a time machine that can leap forward bias are all potential blind spots that can impact the objective
1, 3, or 5 years into the future. We then ask for a potential decision-making of the professionals on any investment team.
newspaper headline from that future date. For example, what
might the newspaper say a year from today? Has inflation To address these biases we have developed proprietary Portfolio
peaked and dropped? Where is the Fed on interest rates? Is the Exercises that are fully integrated into our investment process. The
war in Ukraine over? exercises have proven to be a great tool for the group, helping both
individuals and the team as a whole deliver better client outcomes.
One might argue it’s a fool’s errand to try and predict the We find that some exercises result in immediate changes to our
future. But the point of the exercise is not about predictions per portfolios, and others stimulate new thinking and ideas. We believe
se, but identifying future scenarios that are not in the current these Portfolio Exercises are important differentiators that set us
narrative of the market. The intention is to help us to avoid apart from other investment managers in the industry.
overemphasizing recent events when making long-term decisions
for our clients.
MORGAN STANLEY INVESTMENT MANAGEMENT 5
MACRO INSIGHT
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