Most investors cannot clearly articulate why investment management is so hard. There is the superficial response that it is hard to beat a benchmark, but there is less discussion on why. Of course, costs are very relevant but the difficulty is also associated with the environment faced by investors.
Investors do not always use all the information that is available to them; however this is a not a unique problem to finance but an issue that runs the gamut for all consumer decisions. The explanations for the problem of information usage or non-usage has fallen into two major camps or models of behavior and described nicely in a recent Journal of Economic Perspective article, “Frictions or Mental Gaps: What’s Behind the Information We (Don’t) Use and When Do We Care?” by Benjamin Handel and Joshua Schwartzstein. We present their framework with our view on how the problem can be solved.
McKinsey and Company published an interesting paper on the use of AI in asset management called, “An analytics approach to debiasing asset management decisions”. (Hat tip to Tom Brakke for mentioning the article in his newsletter.) This paper shows the powerful use of analytical tools to extract hidden biases in investment management decision-making. Employing large data sets of manager decisions, companies are finding a wide set of behavioral biases identified in economics present with their decision-making.
Knowledge is the Treasure, but Judgment is the Treasurer of a Wise Man. He that has more knowledge than Judgment, is made for another Man’s use more than his own.
My father used to tell me that brains are like muscles: they can be hired by the hour. It is character and judgment that are not for sale.
And not only the pride of intellect, but the stupidity of intellect. And, above all, the dishonesty, yes, the dishonesty of intellect. Yes, indeed, the dishonesty and trickery of intellect.
The human brain is an inefficient device for noticing, selecting, categorizing, recording, retaining, and manipulating information for inferential purpose.- W.M. Grove and P.E. Meehl
If those are all the things that the human brain is inefficient with, what is left over? A lot, but there has to be focus on using the brain for the right problems and when to change the thinking process.
You should expect that if a group of college-aged students in economics and finance and young financial professionals were given a fixed amount of money and told they can flip and bet on a biased coin with a 60% likelihood of heads they should be able to make money. Don’t bet on it. “Rational decision-making under uncertainty: Observed betting patterns on a biased coin” by Victor Haghani and Richard Dewey is one of those simple studies that really make you question the decision-making skills of even financial professionals. Just under 30% of the players in this game went bust and another 5% lost money. Just under 25% got it right in terms of using an optimal betting strategy that maxed wealth.