How you can overcome human biases in your portfolio

I’ve always found human psychology fascinating. In fact, I even studied it at university (and no, I have no ability whatsoever to read anyone’s minds… wouldn’t that be handy in interviews?) 

So, I was understandably chomping at the bit to see a session covering how to overcome human biases in investing with Macquarie Asset Management’s Blair Hannon at the ASX Investor Day 2024.

Let’s just say the session delivered. Here’s what I learnt (alongside the fact I am definitely my portfolio’s weakest link!)

The human biases to watch

Hannon cited Nobel prize-winning psychologists Daniel Kahneman, Vernon L Smith and Amos Tversky in his explanation of human irrational behaviour – so if you want more, there are an abundance of books by these experts to look out for.

But in short, here’s what you need to know:

• Narrative fallacy: investing based on stories rather than evidence (got a hot tip from a friend and bought without checking?)
• Anchoring: using previous prices as a basis for determining value (i.e. why people pile into expensive stocks that are climbing without checking the fundamentals)
• Herding: copying actions of earlier investors. Hannon points to the toilet paper hoarding crisis of COVID-19 as a key example of this.
• Overreaction: a strong reaction to new information that means a stock becomes overbought or oversold.
• Recency bias: placing too much emphasis on more recent experiences.
• Loss Aversion: investors focus on avoiding losses rather than making gains because a loss feels significantly worse than a gain.
• Lottery effect: accepting a high probability of poor returns for a small chance of a big reward. Buying a lotto ticket is the obvious example, you have a near-100% chance of complete loss of your investment (and yet we’ve already spent the winnings in our heads long before we buy the ticket).
• Overconfidence: the tendency for investors to overestimate their abilities. As Hannon points out, 80% of people think they are above-average drivers – but the reality is we can’t all be above-average.

Some of the biggest investment mistakes we make are due to the above.

I’m absolutely guilty of a few purchases because I simply liked the stories and did nothing to check a company’s fundamentals. 

People lost millions of dollars back in the GFC from panic selling their investments to avoid losing more money (and aside from certain companies, probably would have regained the losses and more had they stayed invested). As to the lottery effect, ever bought a speculative micro-cap simply because you hoped it might end up a 10-bagger despite having horrible fundamentals?

What can we do about it?

While knowing these biases exist is one helpful way of starting to make more carefully measured investment decisions, there is another option.

According to Kahneman, “Algorithms that are constructed on the back of statistical analyses often outperform human judgment, even that of experts.”

That is, taking a quantitative approach, or as Hannon describes it, a systematic approach – though he cautions it is impossible to do by yourself.

“It’s the best of index and active investing. You utilise things like fundamental data for the stocks, but also the data across the entire universe of stocks,” he says.

For instance, quant data might combine with additional information from a company meeting or company releases. It will pull in specific signals (not just quality, it can be value or that can be predictive of an outlook for a sector or region.)

“You’ve got 700 to 1000 data points per stock. You’ve got 27,000 stocks. It’s just not possible. No human, no single person can do that across the entire universe,” Hannon says.

Hannon shares the examples of the Macquarie Core Australian Equity Active ETF (ASX: MQAE) and Macquarie Core Global Equity Active ETF (ASX: MQEG) as how a systematic approach might look in reality. You can see how the signal pool is used, with what signals are important and rank well for different sectors and regions in the image below.

Things for investors to think about

Using managed investments like ETFs can be a way to reduce your own human biases over time – but add in a checklist before you invest.

Hannon suggests the following “consistent alpha” checklist to add to your research:

• Length of the track record of the fund manager
• Performance in different market cycles
• The level of risks undertaken for performance
• Performance during drawdowns.

After all, every little bit of consistent performance matters over time.

You can watch some of the highlights in the video below: