A new research report suggests that cognitive biasesinfluence investment choices of asset managers, creatingidentifiable lifecycles as to when they generate alpha – and whenthey stop. (Photo: Shutterstock)

(Bloomberg Opinion) — A new research report suggests thatcognitive biases influence the investment choices made by asset managers, creating identifiablelifecycles as to when they generate alpha – and, more importantly,when they stop.

Cognitive biases are patterns of behavior that can lead us tomake bad decisions and suboptimal judgments.

A researcher whose firm analyzes behavioral patterns forinvestors and traders, came up with four distinct portfolio managerprofiles at a conference in London this week.

Chris Woodcock, head of research at Essentia Analytics inLondon, analyzed 3.5 million data points from more than 40portfolios around the world that employ a range of differentinvestment styles and have time horizonsranging from a handful of days to several months.

Out of that, he derived 12,000 so-called episodes, tracking fromwhen the managers first bought a stake in a company to when theysold their final share.

The bad news for investors is that the most desirable profile isa rare beast; the worse news is that the most commondestroys returns.

#1: The Linear Accumulator

The first, which he dubs “the Linear Accumulator,” is the onewe'd all love our pension pots to track.

Although there's a period of underperformance versus thebenchmark at the very start of the investment period, thisportfolio manager would generate significant alpha over the entirelifecycle. There's a problem though. Essentia's founder, ClareFlynn-Levy, told the conference she has never come acrossa linear accumulator.

#2: The Coaster

A second investment profile, called “the Coaster,” underlinesWoodcock's underlying thesis that “alpha has a lifecycle that ismeasurable” and that there's “a clear overall trend of long-termdecay.”

For the first half of the holding period, the investmentoutperforms its benchmark. For the second half, though, it treadswater at best.

#3: The Hopeless Romantic

That still beats the third profile, though, which Woodcock dubs“the Hopeless Romantic.”

A brief period of outperformance is swiftly followed by steadyperiod of decline. The problem identified here isn't only thatportfolio managers fall in love with the stocks they've bought as aresult of the well-studied endowment effect, which leads us toovervalue something we already own.

Rather, they're besotted by the analytical work they've alreadyundertaken during the equity selection process and find itdifficult to take on the additional “cognitive load in startingfrom scratch,” Woodcock says.

The most worrying investment profile, though, is the one thatthe study found to be by far and away the most common in thedata.

#4: The Round Tripper

The “Round Tripper” investment spends the bulk of its lifegenerating alpha above and beyond its benchmark. When the goodtimes end, though, the decline is precipitous.

On average, the study found that investment managers experienceda 400 basis-point decay in peak-to-trough for their assetchoices.

Why inbuilt biases are so hard to overcome

Given the huge body of research out there that details ourinbuilt biases, why are they so hard to overcome? One problem isknown as algorithm aversion, our tendency to accept data thatreinforces what we already think, but to be more skeptical ofnumbers when they go against our intuitions.

Moreover, the kinds of people who are attracted to a career inasset management tend to be have more analytical personality types;unfortunately, those are also the people most susceptible toscreening data selectively to fit their existingpreconceptions.

When analyzing their processes, fund managers are typicallyrigorous in scrutinizing the research methodology behind aparticular stock pick. But they don't appear so eager to look atthe psychology behind those decisions or, indeed, the choice ofwhich models and data they use in the first place.

This matters. We prefer narrative, stories about how the worldworks, rather than probabilities. But that same desire may actuallyharm returns. Managers would be be better off applying moreintrospection and devoting more attention to the assumptions behindthe decisions they are paid to make.

No wonder, then, that active management is having such a hardtime proving its worth.

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