The Evidence-Based Investor

Tag Archive: self-attribution bias

  1. Luck pretending to be skill: self-attribution bias in active management

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    Self-attribution bias is the tendency to attribute success to one’s own skills and abilities while attributing failures to external factors like luck or circumstances. We’re all guilty of it, and a new study shows that it’s rife in active fund management.

     

    Think back to your time at school or university. The chances are, like most of us, some of your exam results were better than others. Now try to recall what you might have said — to yourself and to other people — in both of those instances.

    When students score top marks in an exam, they tend to put it down to their own intelligence or hard work. When they mess up, they might blame the teacher for not explaining the course material better, or the exam board for setting such difficult questions.

    This is a classic example of what behavioural psychologists call self-attribution bias. The term refers to the way we tend to attribute positive outcomes to our own abilities or efforts, while attributing negative outcomes to factors beyond our control.

    It happens in all walks of life. A CEO, for example, will often attribute good financial results to positive changes they’ve introduced, and poor results to, say, the economic climate. Similarly, a football manager might tell himself that victories are down to his tactical nous, while blaming defeats on poor refereeing or plain bad luck.

    Studies have shown how the same thing happens in investing. When our returns are good we like to congratulate ourselves for making astute decisions; when they’re poor, we might blame our financial adviser, or the newspaper columnist whose tips we were acting on.

     

    Pros are susceptible too

    But it’s not just ordinary investors who display self-attribution bias. Financial professionals are guilty of it too. Now a new study, entitled Heads I Win, Tails It’s Chance, by Meng Wang from Georgia State University, shows just how prevalent the bias is among active fund managers and how it negatively impacts their performance.

    Wang used artificial intelligence software to examine the statements made by US fund managers in official shareholder reports called N-CSR filings that they are required to file with the regulator, the SEC. In these documents, managers typically explain the factors that have either contributed to, or detracted from, their investment performance.

    Wang divided these statements into two — those that linked performance to internal factors such as skilful stock selection, and those that attributed outcomes to external factors such as the economic environment or prevailing conditions in specific sectors. 

    To evaluate the extent to which each manager displayed self-attribution bias,  he created a measure called the self-attribution score (SAS), ranging from -1 to 1. The higher the SAS score, the more likely the fund manager was to  credit themselves for good outcomes and blame external factors for bad ones. 

    The data set  he used included 15,434 shareholder reports associated with 1,969 unique funds between 2006 and 2018.

     

    What the study found

    On average, Meng Wang found, 41% of the factors attributed to performance contributors were external, while 59% were internal. Conversely, 83% of the factors attributed to performance detractors were external, and 17% were internal. 

    Fund managers were, on average, 40.6% more likely to attribute performance contributors to internal factors than performance detractors.

    In other words, the findings suggest that fund managers tend to internalise successes, attributing them to skill, and externalise failures, attributing them to bad luck.

    But more interesting still is the finding that managers who displayed a stronger self-attribution bias tended to engage in more trading in the subsequent reporting period. Studies have shown that fund managers who trade more frequently are often overconfident and inclined to take excessive risks. These traits, in turn, are usually associated with inferior investment performance.

    Another finding of note is that although the funds Wang looked at exhibited a higher self-attribution bias after periods of strong performance, biased attribution only influenced fund flows when funds performed poorly. To put it another way, investors ignored managers’ self-attribution bias when the fund performed well, thereby exhibiting self-attribution bias themselves in their choice of funds.

     

    Lessons for investors

    It’s already well documented that behavioural biases can be very detrimental to investment returns. It’s often suggested, however, that fund managers and other investment professionals are somehow immune to these biases, or at least less likely to succumb to them than the rest of us. However this latest study is one of many which show that professionals are affected as well.

    More worrying still for those investors who use actively managed funds is that fund managers who exhibit self-attribution bias are also more likely to be overconfident and to engage in excessive risk-taking. There have certainly many instances of “star” managers whose performance flopped as a result of taking on too much risk.

    Investors should stay on their guard against their own irrational tendencies. They should avoid acting on their emotions or following the herd. They should also be mindful of their own limitations and pay more attention to long-term trends than to recent events. 

    But they should also be wary of the behavioural biases of financial professionals acting on their behalf, including financial advisers and, especially, fund managers.

    Remember, the best way to avoid any negative impact from behavioural biases is to use index funds — or other systematic, rules-based funds — that take human behaviour out of the decision-making process altogether.

     

    ABOUT THE AUTHOR

    ROBIN POWELL is the editor of The Evidence-Based Investor. He works as a journalist, author and consultant specialising in finance and investing. He is the co-author of two books, Invest Your Way to Financial Freedom and How to Fund the Life You Want, and his company Regis Media provides high-quality video content for advice firms and other financial businesses.

     

    ALSO BY ROBIN POWELL

    A watershed moment for UK financial advice

    There’s hope yet for St James’s Place

    Private credit has its dangers — caveat emptor

     

    CONTENT FOR ADVICE FIRMS

    Through our partners at Regis Media, TEBI provides a wide range of high-quality content for financial advice and planning firms. The material is designed to help educate clients and to engage with prospects.  

    As well as exclusive content, we also offer a wide range of pre-produced videos which explain how investing works and the valuable role that a good financial adviser can play.

    If you would like to find out more, why not visit the Regis Media website and YouTube channel? If you have any specific enquiries, email Robin Powell, who will be happy to help you.

     

    © The Evidence-Based Investor MMXXIII

     

     

  2. The control delusion

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    It shouldn’t really be a surprise by now, but when it comes to investment we humans are nowhere near the cool and calculating machines the textbooks make us out to be. This is the first of a new series which will look at discoveries in the fascinating field of behavioural finance, starting with the delusion that we have far more control over things than we actually do.

     

    In an Indian Premier League cricket match, the opening batsman in one team ordered his minders to search his hotel room for his missing “lucky” bat. The bat turned up just in time for the first ball to be bowled. But the star batsman ended up being bowled for a duck anyway. 

    Like sports stars who hang their success on lucky charms or pre-match rituals, some investors cling on to their own superstitions. These might include selling a stock that has risen for five sessions, or avoiding the “spooky” month of September or taking cues from the Superbowl.

    When these individuals’ portfolios perform strongly, they might put it down to their own stock selection acumen. But when their portfolios suffer, they tend to pin the blame on factors beyond their control. Rarely do they consider the possibility that all of these possible outcomes are just random.

     

    Behavioural finance view

    Behaviouralists have a phrase for this tendency to claim credit for all the good things that happen and to disown the bad ones: “Self-attribution bias”. This behaviour springs from the illusion of control, a psychological need to believe we have more agency than we actually do.

    The illusion of control was first documented in 1970s by US psychologist Ellen Langer, who in a series of experiments where there were random outcomes — like picking a card from a deck — people tended to see causality when there was none. So they might have more confidence about the outcome if they were cutting the deck themselves than if somebody else was.

    You often see this tendency in casinos where people playing craps tend to throw the dice harder in expectation of a high number and softer in the hope of getting a lower number.

    In investment, people who sell out of the market ahead of a steep fall or buy in before a big rise might start to believe they have “cracked the code” and will exercise that strategy again and again, often without further success.

    This illusion is ultimately self-defeating. The investor fails to reap the benefit of good markets, and then in down markets, makes a bad situation worse. He (and it is usually a “he”) buys high and sells low or bets the house on a concentrated portfolio that leaves him prone to otherwise diversifiable risks related to individual stocks or sectors.

    You also see the illusion of control in the so-called “hot hand fallacy” in which investors chase last year’s returns or back stock pickers they believe are on a winning streak. But even if those stock pickers have had a run of wins, we know every winning streak must end. The assumption these speculators make is to assume that past trades affect future ones.

     

    The power of letting go

    Of course, it doesn’t have to be this way. While our behavioural biases will always be with us and often are useful in our everyday lives, we can help ourselves by limiting their influence on our investment decisions and paying attention to those things within our control — like diversification and discipline.

    By its very nature, the stock market will rise and fall. Uncertainty never goes away and volatility tends to increase when there is greater uncertainty than usual. Of course, it’s human to want to have control over outcomes, but we have to accept that day-to-day fluctuations are unpredictable.

    In a way, letting go of the control fallacy is liberating because it frees you from the burden of believing you are responsible for things well outside your zone of influence. By letting go of those illusions, you are actually better able to maintain control over what you can deal with.

    The outcome is that your investment decisions are based more on evidence than on speculation, superstition or guesswork. And because of that, you are more likely to reach the goals that you have set for yourself.

     

    PREVIOUSLY ON TEBI

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    FIND AN ADVISER

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    That’s why we’re now offering a service called Find an Adviser.

    Wherever they are in the world, we will put TEBI readers in contact with an adviser in their area (or at least in their country) whom we know personally, who shares our evidence-based investment philosophy and who we feel is best able to help them. If we don’t know of anyone suitable we will say.

    We’re charging advisers a small fee for each successful referral, which will help to fund future content.

    Need help? Click here.

     

    Picture: Agni B via Unsplash

     

    © The Evidence-Based Investor MMXXI

     

     

  3. Overconfidence — investors’ worst enemy

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    By LARRY SWEDROE

     

    One of the questions I’m often asked by the media is “What are the biggest risks facing investors?” My usual response is that the biggest risk confronting most investors is staring at them in the mirror. Research from the field of behavioural finance, the study of human behaviour and how that behaviour leads to investment errors, as well as the mispricing of assets, demonstrates that investors aren’t always fully rational—they aren’t always “economically” logical in their actions, but what we can call “psycho” logical. And one of the biggest mistakes is that investors are overconfident of their skills.

    Kent Daniel and David Hirshleifer, authors of the paper Overconfident Investors, Predictable Returns, and Excessive Trading, discussed the role overconfidence plays in investor returns. They cited a wealth of literature which demonstrates:

     

    People tend to be over-optimistic about their life prospects, and this optimism directly affects their final decisions.

    Overconfidence has been documented among experts and professionals, including corporate financial officers as well as professional traders and investment bankers.

    Overconfidence includes over-placement (over-estimation of one’s rank in a population on some positive dimension) and over-precision (over-estimation of the accuracy of one’s beliefs). An example is the overestimation of one’s ability to predict stock market returns.

    A cognitive process that helps support overconfident beliefs is self-attribution bias — people credit their own talent and abilities for past successes while blaming their failures on bad luck. Self-attribution bias allows overconfidence to persist. When investors “get it right,” they upgrade their confidence in their beliefs; when they “get it wrong,” they fail to downgrade it.

    Individual investors trade individual stocks actively, and on average lose money by doing so. The more actively investors trade (due to overconfidence), the more they typically lose.

    The stocks that individual investors buy tend to subsequently underperform, and the stocks they sell tend to subsequently outperform.

    Actively managed funds that charge high fees without delivering correspondingly high performance provides evidence that most individual investors in active funds are overconfident about their ability to select high-performing managers.

    Men are more overconfident than women in decision domains traditionally perceived as masculine, such as financial matters. Overconfidence leads to more trading. One study found that, consistent with higher confidence on the part of men, the average turnover for accounts opened by men is about 1.5 times higher than for accounts opened by women, and as a result, men pay almost one per cent per year more in higher transaction costs and their net-of-fee returns are far lower.

    Individual investors tend to trade more after they experience high stock returns.

    Overconfidence is likely to be especially important when security markets are less liquid and when short-selling is difficult or costly (i.e. limits to arbitrage are at work). When short-selling becomes constrained, pessimists find it harder to trade on their views than optimists, resulting in overpricing. Thus, when overconfidence is combined with constraints on short sales, we expect the security to become overpriced.

    Overconfidence plays a greater role the more analysts disagree, as measured by the dispersion in their forecasts of a firm’s future earnings. Firms with the largest dispersion of forecasted earnings tend to become overpriced because the more pessimistic investors don’t express their views through trading. Thus, on average, these stocks earn lower returns.

    Because volatility creates a greater scope for disagreement, the overpricing of more volatile stocks is more prevalent — high-idiosyncratic-volatility stocks earn lower subsequent returns than low-volatility stocks.

     

    The latest contribution to the literature on confidence is from Brad Barber, Xing Huang, Jeremy Ko and Terrance Odean, authors of the August 2019 study Leveraging Overconfidence. They hypothesised that “overconfident investors with a budget constraint use leverage more, trade more, and perform worse than well-calibrated investors.” To confirm their hypothesis, they analysed the behaviour and performance of retail investors who use margin. Using survey data from the National Financial Capability Study administered by the FINRA Investor Education Foundation, they analysed responses of 1,601 respondents from the 2015 Investor Survey; 37 percent of them have a margin account and 18 percent have experience buying stock on margin. Survey respondents took two quizzes: a 10-question quiz that measures investment literacy, and a six-question quiz that measures financial literacy. Separately, respondents were asked to self-assess their investment knowledge and financial knowledge. They measured overconfidence in investment knowledge as the difference in a respondent’s percentile rank on self-assessed investment knowledge less the respondent’s percentile rank on the financial investment quiz. They found that investors who trade on margin have greater overconfidence than both investors with margin accounts but no margin experience and investors with cash accounts. For example, investors with experience trading on margin are at the 65th percentile in their self-assessed financial knowledge, but the 37th percentile on quizzed financial knowledge.

    The authors then used an older data set that Barber had used in prior research. The data was from a large discount broker covering the period 1991 to 1996. They analysed the trading and performance for the non-retirement accounts of over 43,000 investors; 66 percent have only margin accounts, 34 percent have only cash accounts, and 13 percent have experience using margin. They found that margin account investors, but especially margin experience investors, trade more, and more speculatively, than cash investors. Note that some trading could be attributed to tax-loss selling, or sales not followed by another purchase (used to raise cash), neither of which would be considered speculative.

    They also found that margin investors have worse security selection ability than cash investors. A long-short portfolio that follows the trades of margin investors loses 35 basis points per day. Cash investors did slightly better, losing “only” 25 basis points per day. The greater degree of overconfidence of margin investors not only led them to trade more often, but their stock-picking skills were even worse than the bad stock-picking skills of cash investors. The security selection skills of margin investors are so bad that their mean returns after buys were negative and returns after sells were positive. It was also interesting to note that margin investors tend to have higher incomes and wealth—their higher income levels and greater wealth may have contributed to their overconfidence. 

    The above findings are consistent with those of studies of retail foreign exchange traders. Rawley Heimer and Alp Simsek, authors of the study Should Retail Investors’ Leverage Be Limited? published in the June 2019 issue of the Journal of Financial Economics, found that “leverage-constraint reduces trading volume by 23%, alleviates high-leverage traders’ losses by 40%, and reduces brokerages’ operating capital by 25%.”

    Barber, Huang, Ko and Odean added this important point: overconfidence is not limited to retail investors. They offered the example of Long-Term Capital Management (LTCM), which began by using only long-short strategies that were designed to exploit anomalies. However, likely due to overconfidence, they eventually added absolute-return trading strategies with high financial leverage. While initially successful, they ultimately resulted in $4.6 billion in losses in the wake of the 1997 Asian financial crisis.

    They also noted that their results are applicable to other markets. For example, “in housing markets, where leverage is readily accessible and often used, overconfident homebuyers might use more leverage, speculate more, and thereby potentially facilitate the formation of a bubble.”

    The authors concluded: “In sum, our evidence indicates that overconfidence — not better information — is a primary motivation for retail investors to trade, to their detriment, on margin. More generally, our analysis suggests overconfidence and leverage can be a dangerous mix.”

     

    Summary

    The findings of Barber, Huang, Ko and Odean are entirely consistent with prior research demonstrating that individual investors are overconfident about their ability, and trade to their detriment. Before you conclude that this is true of others, but not you, remember that the research demonstrates it doesn’t matter what the question is — whether you are a better-than-average driver, you are liked more by others than the average person, or you are smarter than average — the typical survey finds that 80 percent or more believe they are above average. Overconfidence is particularly dangerous to investors because it can lead to not only excessive trading, but also a failure to diversify sufficiently to minimise idiosyncratic risks for which investors are not compensated. Forewarned is forearmed. 

     

    LARRY SWEDROE is Chief Research Officer at Buckingham Strategic Wealth and the author of 17 books on investing, including Think, Act, and Invest Like Warren Buffett.
    If you’re interested in reading more of his work, here are his other most recent articles for TEBI:

    Explaining decreasing returns to scale in active management

    More evidence that passive funds are superior to active

    Value premium RIP? Don’t you believe it

    Third quarter 2019 hedge fund performance update

    Sequence risk is a big threat to retirees