How Are Our Investment Decisions Affected by Cognitive Biases?

  1. Why do we, as private investors, think we can time the market and select investment strategies better than a professional fund manager?

    • This lack of self-knowledge is not limited to retail investors, I know for a fact that many professional fund managers overestimate their ability to time the market or beat the market

    • The evidence for underperformance is very clear e.g. S&P Index versus Active reports (SPIVA)

      • 83% of US large-cap active funds underperformed the S&P 500 over a decade

      • 83% of European equity funds funds underperformed the S&P Europe 350 over a decade

      • In Canada it’s 81%, Australia 80%, Japan 82%, GBP denominated funds investing in UK equity 62%, global equity 90%

    • Given the statistics for professional investors the results for retail investors is likely to be worse given the more limited resources, time and skill

    • This is not limited to investment e.g. most drivers think they are above average in their driving skill

  2. Do we have overconfidence in our own decisions?

    • Nicholas Barberis who works in behavioural finance splits this into two categories

      • Overplacement where we judge ourselves to be more skillful relative to other people than we truly are

      • Overprecision where we think our estimates are more accurate than they truly are

    • These biases explain a lot of what happens in markets

      • Trading volumes are higher than you’d expect if investors are rational

        • Those who trade the most do the worst!

        • If we believe our judgement of the value of a stock is better than other investors we think we’re buying at a bargain price or selling at a price that is too high and that the person on the other side of the trade is just wrong

        • If we believe other investors have good judgement we would be less willing to trade i.e. if someone wants to sell us a stock maybe they are right that it’s too expensive, so this should be sending us a negative signal and stop us from buying

      • Why are there so many Merger & Acquisitions given the strong evidence that they don’t add value?

        • CEOs are overconfident!

        • Here’s a quote from Warren Buffett letter to investors published in 1982

        • “Many managements apparently were overexposed in impressionable childhood years to the story in which the imprisoned handsome prince is released from a toad’s body by a kiss from a beautiful princess.  Consequently, they are certain their managerial kiss will do wonders for the profitability of Company T(arget).

          Such optimism is essential.  Absent that rosy view, why else should the shareholders of Company A(cquisitor) want to own an interest in T at the 2X takeover cost rather than at the X market price they would pay if they made direct purchases on their own?

          In other words, investors can always buy toads at the going price for toads.  If investors instead bankroll princesses who wish to pay double for the right to kiss the toad, those kisses had better pack some real dynamite.  We’ve observed many kisses but very few miracles.  Nevertheless, many managerial princesses remain serenely confident about the future potency of their kisses – even after their corporate backyards are knee-deep in unresponsive toads.”

  3. Would we be better in the long term, closing our eyes and just buying a global equity tracker, or does asset class diversification still have any benefits in this market?

    • All we can do is look at historical returns for different asset classes and portfolios and make the assumption that the future will resemble the past

    • Return is roughly the weighted average of asset returns, the only (non-linear) deviation from that is due to rebalancing

      • If you put 60% into equity, 40% into bonds your return at the end of a period will be 60% of the equity return and 40% of the bond return

    • Risk is not a linear combination because of correlation i.e. volatility is lower than either of two asset classes if they have negative correlation between returns

      • If you put 60% into equity, 40% into bonds the volatility may be less than the volatility of either equity or bonds

  • The CRSP database (Center for Research in Security Prices) has data going back to 1926 and their average returns from 1926-2021 are

    • US stocks 10.3%

    • Growth Portfolio 9.4%

    • Balanced Portfolio 8.4%

    • International Stocks 8.0%

    • Income Portfolio 6.5%

    • Bonds 5.1%

    • T-Bills 3.6%

    • Inflation 2.9%

  • Definitions

    • International stocks exclude US stocks

    • Growth Portfolio: 55% US Large Cap Stocks, 25% Bonds, 15% International Stocks, 5% US Small Cap Stocks

    • Balanced Portfolio: 55% US Large Cap Stocks, 35% Bonds, 10% T-Bills

    • Income Portfolio: 55% Bonds, 25% US Large Cap Stocks, 20% T-Bills (doesn’t add to 100!)

  • If you want the largest possible return you’d go for equity but you have to live with the higher volatility and stomach-churning losses occasionally

  • It also depends on what you mean by “better”

  • This isn’t always the highest return!

  • The risk of not meeting your financial goals is probably what most people mean by risk

  • A 100% equity portfolio on average will have the highest return long-term but if you’re looking at a drawdown portfolio the sustainable withdrawal rate for a 100% equity portfolio is quite poor because in some historic periods equity tumbled early in retirement and sequencing risk meant a higher risk of shortfall

  • You can experiment with this yourself with PortfolioCharts


  1. If we believe in asset diversification and timing the market would we be better sticking with an active fund manager?

    • Performance of multi-asset managers is as bad as equity managers and usually comes with a high fee

    • Fixed income also comes with underperformance

    • See the summary of reports from Finalytiq e.g. 

      • In our 2019 instalment of the Multi-Asset Fund Report, our research covered 89 fund families, consisting of 391 multi-asset funds, which collectively hold £125.7bn of client money. Our key findings were as follows:

        • The vast majority of multi-asset funds continued to underperform the No-Brainer portfolios (global equity & hedged global bond two-fund portfolios) on a risk-adjusted basis

        • 10 fund families delivered greater risk-adjusted returns than the average of our No-Brainer portfolio benchmarks over a five-year observation period. Costs were generally high e.g. Ongoing Charges Figures were

        • Highest – 2.91%

        • Upper Quartile – 1.29%

        • Median – 0.95%

        • Lower Quartile – 0.63%

        • Lowest – 0.16%